The Spaniards coming into the West Indies had many commodities of the country which they needed, brought unto them by the inhabitants, to who when they offered them money, goodly pieces of gold coin, the Indians, taking the money, would put it into their

1. Answer the following questions using the data in Exhibit 7.5, page 275.

a. How many Swiss francs can you get for one dollar?

b. How many dollars can you get for one Swiss franc?

c. What is the three-month forward rate for the Swiss franc?

d. Is the Swiss franc selling at a forward premium or discount?

e. What is the 90-day forward discount or premium on the Swiss franc?

2. What risks confront dealers in the foreign exchange market? How can they cope with those risks?

3. Suppose a currency increases in volatility. What is likely to happen to its bid-ask spread? Why?

4. Who are the principal users of the forward market? What are their motives?

5. How does a company pay for the foreign exchange services of a commercial bank?

Problems

1. The $/€ exchange rate is €1 = $1.45, and the €/SFr exchange rate is SFr 1 = €0.71. What is the SFr/$ exchange rate?

2. Suppose the direct quote for sterling in New York is 1.9110-5.

a. How much would £500,000 cost in New York?

b. What is the direct quote for dollars in London?

3. Using the data in Exhibit 7.5, calculate the 30-day, 90-day, and 180-day forward premiums for the Canadian dollar.

4. An investor wishes to buy euros spot (at $1.3908) and sell euros forward for 180 days (at $1.3996).

a. What is the swap rate on euros?

b. What is the forward premium or discount on 180-day euros?

5. Suppose Credit Suisse quotes spot and 90-day forward rates on the Swiss franc of $0.7957-60, 8-13.

a. What are the outright 90-day forward rates that Credit Suisse is quoting?

b. What is the forward discount or premium associated with buying 90-day Swiss francs?

c. Compute the percentage bid-ask spreads on spot and forward Swiss francs.

6. Suppose Dow Chemical receives quotes of $0.009369-71 for the yen and $0.03675-6 for the Taiwan dollar (NT$).

a. How many U.S. dollars will Dow Chemical receive from the sale of ¥50 million?

b. What is the U.S. dollar cost to Dow Chemical of buying ¥1 billion?

c. How many NT$ will Dow Chemical receive for U.S.$500,000?

d. How many yen will Dow Chemical receive for NT$200 million?

e. What is the yen cost to Dow Chemical of buying NT$80 million?

7. Suppose the euro is quoted at 0.6064-80 in London and the pound sterling is quoted at 1.6244-59 in Frankfurt.

a. Is there a profitable arbitrage situation? Describe it.

b. Compute the percentage bid-ask spreads on the pound and euro.

8. As a foreign exchange trader at Sumitomo Bank, you have a customer who would like spot and 30-day forward yen quotes on Australian dollars. Current market rates are

Spot

30-day

¥101.37-85/U.S.$1

15-13

A$1.2924-44/U.S.$1

20-26

a. What bid and ask yen cross rates would you quote on spot Australian dollars?

b. What outright yen cross rates would you quote on 30-day forward Australian dollars?

c. What is the forward premium or discount on buying 30-day Australian dollars against yen delivery?

9. Suppose Air France receives the following indirect quotes in New York: €0.92-3 and £0.63-4. Given these quotes, what range of £/€ bid and ask quotes in Paris will permit arbitrage?

10. On checking the Telerate screen, you see the following exchange rate and interest rate quotes:

Currency

90-Day Interest Rates (Annualized)

Spot Rates

90-Day Forward Rates

Dollar

4.99%-5.03%

Swiss franc

3.14%-3.19%

$0.711-22

$0.726-32

a. Can you find an arbitrage opportunity?

b. What steps must you take to capitalize on it?

c. What is the profit per $1 million arbitraged?

Web Resources

www.imf.org/external/fin.htm IMF Web page that contains exchange rate quotes for selected currencies.

www.ny.frb.org/markets/fxrates/noon.cfm Web page of the Federal Reserve Bank of New York that lists daily noon foreign exchange rates.

www.oanda.com Contains a wide variety of current and historical exchange rate data along with stories relating to foreign exchange and links to the world's central banks.

www.ny.frb.org/education/addpub/usfxm/Lists of online publications by the Federal Reserve Bank of New York that offer detailed information about the foreign exchange market in the United States.

www.bis.org/publ/index.htm Contains the BIS Annual Report, statistics on derivatives, external debt, foreign exchange market activity, and so on.

emgmkts.com/pricing/fxclose.htm Contains quotes for a variety of emerging currencies, although it does not appear to have been updated lately.

www.bloomberg.com Web site for Bloomberg. Contains a wide variety of data on financial markets worldwide, including foreign exchange and interest rate data.

Web Exercises

1. Find the latest quotes for the euro, pound, and yen. By how much did these currencies rise or fall against the dollar in the last day?

2. Have emerging market currencies generally risen or fallen in the past day? You can use the Emerging Markets Companion for these data or the IMF Web site.

3. What was the volume of forward contracts traded in the past year? You can use data from the BIS Annual Report to answer this question.

4. Find the currency cross rates provided by

Bloomberg for the euro/pound and euro/yen. Using these rates, calculate what the pound/yen cross rate should be. Compare your calculated pound/yen cross rate to the one reported by Bloomberg. Are the two cross rates the same?

Bibliography

Bessembinder, Hendrik. “Bid-Ask Spreads in the Interbank Foreign Exchange Markets.” Journal of Financial Economics, June 1994, pp. 317-348.

Fama, Eugene. “Forward and Spot Exchange Rates.” Journal of Monetary Economics, 14 (1984): 319-338.

Glassman, Debra. “Exchange Rate Risk and Transactions Costs: Evidence from Bid-Ask Spreads.” Journal of International Money and Finance, December 1987, pp. 479-491.

Kubarych, Roger M. Foreign Exchange Markets in the United States. New York: Federal Reserve Bank of New York, 1983.

Strongin, Steve. “International Credit Market Connections.” Economic Perspectives, July/August 1990, pp. 2-10.

(Shapiro 264)

Shapiro. Multinational Financial Management, 9th Edition. John Wiley & Sons. .

HAPTER 8 Currency Futures and Options Markets



I dipt into the future far as human eye could see, Saw the vision of the world and all the wonder that would be.

Alfred, Lord Tennyson (1842)

Learning Objectives

• To explain what currency futures and options contracts are and to describe the organization of the markets in which these contracts are traded

• To distinguish between currency forward and futures contracts

• To distinguish between currency futures and options contracts

• To describe the advantages and disadvantages of futures contracts relative to forward contracts

• To explain how currency futures and options contracts can be used to manage currency risk and to speculate on future currency movements

• To identify the basic factors that determine the value of a currency option

• To read and interpret the prices of currency futures and options contracts as they appear in the Wall Street Journal

Key Terms

American option

at-the-money

bear spread

break-even price

bull spread

call option

Chicago Mercantile Exchange (CME)

currency futures

currency option

currency spread

derivatives

European option

exchanged-traded option

exercise price

expiration date

futures contract

futures option

implied volatility

initial margin

initial performance bond

International Monetary Market (IMM)

in-the-money

intrinsic value

knockout option

listed option

maintenance margin

maintenance performance bond

margin call

marking to market

offsetting trade

open interest

out-of-the-money

OTC currency option

outstrike

over-the-counter (OTC) market

performance bond

performance bond call

Philadelphia Stock

Exchange (PHLX)

put-call option interest

rate parity

put option

retail market

round trip

strike price

time value

United Currency Options

Market (UCOM)

Foreign currency futures and options contracts are examples of the new breed of financial instrument known as derivatives. Financial derivatives are contracts that derive their value from some underlying asset (such as a stock, bond, or currency), reference rate (such as a 90-day Treasury bill rate), or index (such as the S&P 500 stock index). Popular derivatives include swaps, forwards, futures, and options. Chapter 7 discussed forward contracts, and Chapter 9 discusses swaps. This chapter describes the nature and valuation of currency futures and options contracts and shows how they can be used to manage foreign exchange risk or to take speculative positions on currency movements. It also shows how to read the prices of these contracts as they appear in the financial press. Appendices 8A and 8B discuss some technical aspects of option pricing.

8.1 Futures Contracts

The Chicago Mercantile Exchange (CME) provides an outlet for currency speculators and for those looking to reduce their currency risks. Trade takes place in currency futures, which are contracts for specific quantities of given currencies; the exchange rate is fixed at the time the contract is entered into, and the delivery date is set by the board of directors of the International Monetary Market (IMM). These contracts are patterned after those for grain and commodity futures contracts, which have been traded on Chicagos exchanges for more than 100 years.

Currency futures contracts are currently available for the Australian dollar, Brazilian real, British pound, Canadian dollar, Chinese renminbi, Czech koruna, Hungarian forint, Israeli shekel, Japanese yen, Korean won, Mexican peso, New Zealand dollar, Norwegian krone, Polish zloty, Russian ruble, South African rand, Swedish krona, Swiss franc, and the euro. The CME is continually experimenting with new contracts. Those that meet the minimum volume requirements are added, and those that do not are dropped. For example, the CME added a number of cross-rate contracts, such as EC/JY and AD/SF cross-rate contracts, while dropping contracts in the Dutch guilder (before it was replaced by the euro). By taking the U.S. dollar out of the equation, cross-rate futures allow one to hedge directly the currency risk that arises in dealing with nondollar currencies. The number of contracts outstanding at any one time is called the open interest.

Private individuals are encouraged, rather than discouraged, to participate in the market. Contract sizes are standardized by the amount of foreign currency—for example, £62,500, C$100,000, and SFr 125,000. Exhibit 8.1 shows contract specifications for some of the currencies traded. Leverage is high; margin requirements average less than 2% of the value of the futures contract. The leverage assures that investors’ fortunes will be decided by tiny swings in exchange rates.

The contracts have minimum price moves, which generally translate into about $10 to $12 per contract. At the same time, most exchanges set daily price limits on their contracts that restrict the maximum daily price move. When these limits are reached, additional margin requirements are imposed and trading may be halted for a short time.

Instead of using the bid-ask spreads found in the interbank market, traders charge commissions. Though commissions will vary, a round trip—that is, one buy and one sell—costs as little as $15. This cost works out to less than 0.02% of the value of a sterling contract. The low cost, along with the high degree of leverage, has provided a major inducement for speculators to participate in the market. Other market participants include importers and exporters, companies with foreign currency assets and liabilities, and bankers.

Exhibit 8.1 Contract Specifications for Foreign Currency Futures ¹

¹ Effective as of July 17, 2008.

Source: Data collected from Chicago Mercantile Exchange's Web site at www.cme.com

Although volume in the futures market is still small compared with that in the forward market, it can be viewed as an expanding part of a growing foreign exchange market. As we will see shortly, the different segments of this market are linked by arbitrage.

The CME is still the dominant trader, but other exchanges also trade futures contracts. The most important of these competitors include the London International Financial Futures Exchange (LIFFE), the Chicago Board of Trade (CBOT), the New York Mercantile Exchange, the Philadelphia Stock Exchange (PHLX), the Singapore International Monetary Exchange (SIMEX), Deutsche Termin Borse (DTB) in Frankfurt, the Hong Kong Futures Exchange (HKFE), the Marché à Termes des Instruments Financiers (MATIF) in Paris, and the Tokyo International Financial Futures Exchange (TIFFE).

A notable feature of the CME and other futures markets is that deals are struck by brokers face to face on a trading floor rather than over the telephone. There are other, more important distinctions between the futures and forward markets.

Forward Contract versus Futures Contract

One way to understand futures contracts is to compare them with forward contracts. Futures contracts are standardized contracts that trade on organized futures markets for specific delivery dates only. In the case of the CME, the most actively traded currency futures contracts are for March, June, September, and December delivery. Contracts expire two business days before the third Wednesday of the delivery month. Contract sizes and maturities are standardized, so all participants in the market are familiar with the types of contracts available, a situation that facilitates trading. Forward contracts, on the other hand, are private deals between two individuals who can sign any type of contract they agree on. For example, two individuals may sign a forward contract for €70,000 in 20 months to be paid in Swiss francs. However, CME contracts trade only in round lots of €125,000 priced in U.S. dollars and with a limited range of maturities available. With only a few standardized contracts traded, the trading volume in available contracts is higher, leading to superior liquidity, smaller price fluctuations, and lower transaction costs.

Once a trade is confirmed, the exchange's clearing house—backed by its members’ capital—becomes the legal counterparty to both the buyer and seller of the futures contract. The exchange members, in effect, guarantee both sides of a contract, largely eliminating the default risks of trading. Members of the futures exchange support their guarantee through margin requirements, marking contracts to market daily (explained later), and maintaining a guarantee fund in the event a member defaults. In contrast, a forward contract is a private deal between two parties and is subject to the risk that either side may default on the terms of the agreement.

The contract specifications in Exhibit 8.1 show the margin requirements (now called performance bonds by the CME) for speculators (members have different margin requirements). The initial performance bond shows how much money must be in the account balance when the contract is entered into. This amount is $1,890 in the case of the pound. A performance bond call is issued if—because of losses on the futures contract—the balance in the account falls below the maintenance performance bond, which is $1,400 for the pound. At that time, enough new money must be added to the account balance to bring it up to the initial performance bond. For example, suppose you start with an initial balance of $2,050 ($160 in excess of the initial performance bond of $1,890) in your account on a pound futures contract and your contract loses, say, $780 in value. It is now $1,270, which is $130 below the maintenance performance bond of $1,400. Hence, you must add $490 to your account to meet the initial performance bond requirement ($2,050 − $780 + $620 = $1,890).

The CME periodically revises its performance bond requirements in line with changing currency volatilities using a computerized risk management program call SPAN, which stands for Standard Portfolio Analysis of Risk. Note also that the performance bond requirements set by the CME are minimums; brokers often require higher performance bonds on more volatile currency contracts.

Profits and losses of futures contracts are paid over every day at the end of trading, a practice called marking to market. This daily-settlement feature can best be illustrated with an example. On Tuesday morning, an investor takes a long position in a Swiss franc futures contract that matures on Thursday afternoon. The agreed-on price is $0.95 for SFr 125,000. To begin, the investor must deposit into his account an initial performance bond of $2,700. At the close of trading on Tuesday, the futures price has risen to $0.955. Because of daily settlement, three things occur. First, the investor receives his cash profit of $625 (125,000 × 0.005). Second, the existing futures contract with a price of $0.95 is canceled. Third, the investor receives a new futures contract with the prevailing price of $0.955. Thus, the value of the futures contracts is set to zero at the end of each trading day.

At Wednesday close, the price has declined to $0.943. The investor must pay the $1,500 loss (125,000 × 0.012) to the other side of the contract and trade in the old contract for a new one with a price of $0.943. At Thursday close, the price drops to $0.94, and the contract matures. The investor pays his $375 loss to the other side and takes delivery of the Swiss francs, paying the prevailing price of $0.94, for a total payment of $117,500 (125,000 X $0.94). The investor has had a net loss on the contract of $1,250 ($625 − $1,500 − $375) before paying his commission. Exhibit 8.2 details the daily settlement process.

Daily settlement reduces the default risk of futures contracts relative to forward contracts. Every day, futures investors must pay over any losses or receive any gains from the day's price movements. These gains or losses are generally added to or subtracted from the investor's account. An insolvent investor with an unprofitable position would be forced into default after only one day's trading rather than being allowed to build up huge losses that lead to one large default at the time the contract matures (as could occur with a forward contract). For example, if an investor decided to keep his contract in force, rather than closing it out on Wednesday, he would have had a performance bond call because his account would have fallen below the maintenance performance bond of $2,000. His performance bond call would be for $875 ($2,700 + $625 − $1,500 + $875 = $2,700) at the close of Wednesday trading in order to meet his $2,700 initial performance bond; that is, the investor would have had to add $875 to his account to maintain his futures contract.

Futures contracts can also be closed out with an offsetting trade. For example, if a company's long position in euro futures has proved to be profitable, it need not literally take delivery of the euros when the contract matures. Rather, the company can sell futures contracts on a like amount of euros just prior to the maturity of the long position. The two positions cancel on the books of the futures exchange, and the company receives its profit in dollars. Exhibit 8.3 summarizes these and other differences between forward and futures contracts.

Exhibit 8.2 An Example of Daily Settlement with a Futures Contract

Exhibit 8.3 Basic Differences between Forward and Futures Contracts

Application Computing Gains, Losses, and Performance Bond Calls on a Futures Contract

On Monday morning, you short one CME yen futures contract containing ¥12,500,000 at a price of $0.009433. Suppose the broker requires an initial performance bond of $4,000 and a maintenance performance bond of $3,400. The settlement prices for Monday through Thursday are $0.009542, $0.009581, $0.009375, and $0.009369, respectively. On Friday, you close out the contract at a price of $0.009394. Calculate the daily cash flows on your account. Describe any performance bond calls on your account. What is your cash balance with your broker as of the close of business on Friday? Assume that you begin with an initial balance of $4,590 and that your round-trip commission was $27.

Solution

Time

Action

Cash Flow on Contract

Monday morning

Sell one CME yen futures contract. Price is $0.009433.

None.

Monday close

Futures price rises to $0.009542. Contractis marked to market.

You pay out

12,500,000 × (0.009433 − 0.009542) − $1,362.50

Tuesday close

Futures price rises to $0.009581. Contract is marked to market.

You pay out an additional

12,500,000 × (0.009542 − 0.009581) = − $487.50

Wednesday close

Futures price falls to $0.009375. Contractis marked to market.

You receive

12,500,000 × (0.009581 − 0.009375) = +$2,575.00

Thursday close

Futures price falls to$0.009369. Contract ismarked to market.

You receive an additional

12,500,000 × (0.009375 − 0.009369) = +$75.00

Friday

You close out your contract at a futures price of $0.009394.

You pay out

12,500,000 × (0.009369 − 0.009394) = − $312.50

You pay out a round-trip commission = − $27.00

Net gain on the futures contract

$460.50

Your performance bond calls and cash balances as of the close of each day were as follows:

Monday

With a loss of $1,362.50, your account balance falls to $3,227.50($4,590 −$1,362.50). You must add $772.50 ($4,000 −$3,227.50) to your accountto meet the initial performance bond of $4,000.

Tuesday

With an additional loss of $487.50, your balance falls to $3,512.50($4,000—$487.50). Your balance exceeds the maintenance performance bond of $3,400 so you need add nothing further to your account.

Wednesday

With a gain of $2,575, your balance rises to $6,087.50.

Thursday

With a gain of $75, your account balance rises further to $6,162.50.

Friday

With a loss of $312.50, your account balance falls to $5,850. After subtracting the round-trip commission of $27, your account balance ends at $5,823.

Advantages and Disadvantages of Futures Contracts.

The smaller size of a futures contract and the freedom to liquidate the contract at any time before its maturity in a well-organized futures market differentiate the futures contract from the forward contract. These features of the futures contract attract many users. On the other hand, the limited number of currencies traded, the limited delivery dates, and the rigid contractual amounts of currencies to be delivered are disadvantages of the futures contract to many commercial users. Only by chance will contracts conform exactly to corporate requirements. The contracts are of value mainly to those commercial customers who have a fairly stable and continuous stream of payments or receipts in the traded foreign currencies.

Arbitrage Between the Futures and Forward Markets.

Arbitrageurs play an important role on the CME. They translate CME futures rates into interbank forward rates and, by realizing profit opportunities, keep CME futures rates in line with bank forward rates.

Application Forward-Futures Arbitrage

Suppose the interbank forward bid for June 18 on pounds sterling is $1.8927 at the same time that the price of CME sterling futures for delivery on June 18 is $1.8915. How could the dealer use arbitrage to profit from this situation?

Solution. The dealer would simultaneously buy the June sterling futures contract for $118,218.75 (62,500 X $1.8915) and sell an equivalent amount of sterling forward, worth $118,293.75 (62,500 X $1.8927), for June delivery. Upon settlement, the dealer would earn a profit of $75. Alternatively, if the markets come back together before June 18, the dealer can unwind his position (by simultaneously buying £62,500 forward and selling a futures contract, both for delivery on June 18) and earn the same $75 profit. Although the amount of profit on this transaction is tiny, it becomes $7,500 if 100 futures contracts are traded.

Such arbitrage transactions as described in the “Forward-Futures Arbitrage” application will bid up the futures price and bid down the forward price until approximate equality is restored. The word approximate is used because of a difference between the two contracts. Unlike the forward contract, with which gains or losses are not realized until maturity, marking to market means that day-to-day futures contract gains (or losses) will have to be invested (or borrowed) at uncertain future interest rates. However, a study of actual rates for the British pound, Canadian dollar, Deutsche mark, Swiss franc, and Japanese yen found that forward and futures prices do not differ significantly.¹

8.2 Currency Options

Whatever advantages the forward or the futures contract might hold for its purchaser, the two contracts have a common disadvantage: Although they protect the holder against the risk of adverse movements in exchange rates, they also eliminate the possibility of gaining a windfall profit from favorable movements. This disadvantage was apparently one of the considerations that led some commercial banks to offer