CHAPTER 7
FOREIGN CURRENCY DERIVATIVES:
FUTURES AND OPTIONS
1. Foreign Currency Futures. What is a foreign currency future?
2. Futures Terminology. Explain the meaning and probable significance for international business of
the following contract specifications:
Specific-sized contract: Trading may be conducted only in preestablished multiples of currency units.
Standard method of stating exchange rates. Rates are stated in “American terms,” meaning the U.S.
Collateral and maintenance margins. An initial “margin,” meaning a cash deposit made at the time a
Counterparty. All futures contracts are with the clearinghouse of the exchange where they are traded.
3. Long and a Short. How do you use foreign currency futures to speculate on the exchange rate
movements, and what role do long and short positions play in that speculation?
Chapter 7 Foreign Currency Derivatives: Futures and Options 39
© 2016 Pearson Education, Inc.
Short Positions. If a currency speculator believes that a foreign currency will fall in value versus the
U.S. dollar (home currency) by a specific date, she could sell that date futures contract, taking a short
position. By selling that date contract, the speculator locks in the right to sell the foreign currency at a
set price—a price that the speculator believes would be higher than the spot rate in the market on that
future date.
Long Positions. If a currency speculator believes that a foreign currency will rise in value versus the
home currency by a specific date, she should buy a specific future date future on the foreign currency.
By buying a currency future, the speculator is locking in the price to buy the foreign currency, which
the speculator expects to be higher in value at that date, therefore generating a profit.
4. Futures and Forwards. How do foreign currency futures and foreign currency forwards compare?
5. Puts and Calls. Define a put and call on the British pound sterling.
6. Options versus Futures. Explain the difference between foreign currency options and futures and
when either might be most appropriately used.
An option is a contract giving the buyer the right but not the obligation to buy or sell a given amount
7. Call Option Contract. You read that exchange-traded American call options on pounds sterling
having a strike price of 1.460 and a maturity of next March are now quoted at 3.67. What does this
mean if you are a potential buyer?
40 Eiteman/Stonehill/Moffett | Multinational Business Finance, 14th Edition
© 2016 Pearson Education, Inc.
sterling on the IMM is £62,500 per contract, meaning that the option will cost you £62,500 × $0.0367
= $2,293.75.
8. Premiums, Prices & Costs. What is the difference between the price of an option, the value of an
option, the premium on an option, and the cost of a foreign currency option?
9. Three Prices. What are the three different prices or “rates” integral to every foreign currency option
contract?
10. Writing Options. Why would anyone write an option, knowing that the gain from receiving the
option premium is fixed but the loss if the underlying price goes in the wrong direction can be
extremely large?
As with all options, what the holder gains, the writer loses, and vice versa. If the writer of a call
option already owns the currency, the writer would be effectively “covered” if the option ends up
11. Decision Prices. Once an option has been purchased, only two prices or rates are part of the holder’s
decision making process. Which two and why?
12. Option Cash Flows and Time. The cash flows associated with a call option on euros by a U.S. dollar
based investor occur at different points in time. What are they and how much does the time element
matter?
Chapter 7 Foreign Currency Derivatives: Futures and Options 41
© 2016 Pearson Education, Inc.
The U.S. dollar investor purchases the option up-front. This is the initial up-front cash outlay for the
option “right,” but also represents the total maximum loss. The buyer of an option cannot lose more
than the cost of the option, the premium. Upon expiration or exercise, if the option is in the money the
investor will exercise the option for profit and a cash settlement on the option. If the option is allowed
to expire out-of-the-money, there is no secondary cash flow associated with the option. There is no
cash exchange with expiration. The time between option purchase and maturity can be very short or
very long, but the time value does not alter the value proposition or decision principles followed by
the investor.
13. Option Valuation. The value of an option is stated to be the sum of its intrinsic value and its time
value. Explain what is meant by these terms.
Intrinsic value for a call option is the amount of gain that would be made today if the option were
exercised today and the underlying shares sold immediately. For a put, intrinsic value is the amount
14. Time Value Deterioration. An option’s value declines over time, but it does not do it evenly.
Explain what that means for option valuation.
15. Option Values and Money. Options are often described as in-the-money, at-the-money, or out-of-
the-money. What does that mean and how is it determined?
16. Option Pricing and the Forward Rate. What is the relationship or link between the forward rate and
the foreign currency option premium?
17. Option Deltas. What is an option delta? How does it change when the option is in-the-money, at-the-
money, or out-of-the-money?
18. Historic Versus Implied Volatility. What is the difference between a historic volatility and an
implied volatility?