Chapter 7
Foreign Currency Derivatives: Futures and Options
◼ Learning Objectives
1. Explain how foreign currency futures are quoted, valued, and used for speculation
purposes
2. Explore the buying and writing of foreign currency options in terms of risk and return
3. Examine how foreign currency option values change with exchange rate movements,
interest rate movements, and other option pricing components over time
◼ Chapter Outline
I. Foreign Currency Futures
A. Contract Specifications
B. Using Foreign Currency Futures
Short Positions
Long Positions
C. Foreign Currency Futures versus Forward Contracts
II. Currency Options
D. Option Fundamentals
E. Foreign Currency Options Markets
Options on the Over-the-Counter Market
Options on Organized Exchanges
F. Currency Option Quotations and Prices
G. Buyer of a Call
Spot rate
Exercise price
Premium
H. Writer of a Call
I. Buyer of a Put
Chapter 7 Foreign Currency Derivatives and Swaps 41
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Standard maturity date. All contracts mature at a preestablished date, being on the third
Wednesday of eight specified months. This means that a firm wishing to use foreign
exchange futures to cover exchange risk will not be able to match the contract maturity
with the risk maturity.
Collateral and maintenance margins. An initial “margin,” meaning a cash deposit made at the
time a futures contract is purchased, is required. This is an inconvenience to most firms
doing international business because it means some of their cash is tied up in an
unproductive manner. Forward contracts made through banks for existing business clients
do not normally require an initial margin. A maintenance margin is also required, meaning
that if the value of the contract is marked to market every day and if the existing margin on
deposit falls below a mandatory percentage of the contract, additional margin must be
deposited. This constitutes a big nuisance to a business firm because it must be prepared
for a daily outflow of cash than cannot be anticipated. (Of course, on some days the cash
flow would be in to the firm.)
Counterparty. All futures contracts are with the clearing house of the exchange where they
are traded. Consequently a firm or individual engaged in buying or selling futures
contracts need not worry about the credit risk of the opposite party.
3. Long and a Short. How can foreign currency futures be used to speculate on the exchange
rate movements, and what role do long and short positions play in that speculation?
4. Futures and Forwards. How do foreign currency futures and foreign currency forwards
compare?
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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.
7. Call Option Contract. Suppose that exchange-traded American call options on pounds
sterling with 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?
8. Premiums, Prices, and Costs. What is the difference between the price of an option, the
44 Moffett/Stonehill/Eiteman • Fundamentals of Multinational Finance, Sixth Edition
© 2018 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.
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?
