CHAPTER 7
FOREIGN CURRENCY DERIVATIVES: FUTURES &
OPTIONS
1. Foreign Currency Futures. What is a foreign currency future?
A future is an exchange-traded contract calling for future delivery of a standard
amount of foreign currency at a fixed time, place, and price. A future requires a
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. This means that a firm wishing to hedge some aspect of its foreign
exchange risk is not able to match the contract size with the size of the risk.
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 a 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.)
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?
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
Long Positions. If a currency speculator beleives that a foreign currency will rise in
value versus the home currency by a specific date, she should buy a specific future
4. Futures and Forwards. How do foreign currency futures and foreign currency
forwards compare?
Foreign currency futures contracts differ from forward contracts in a number of
important ways. Individuals find futures contracts useful for speculation because they
usually do not have access to forward contracts. For businesses, futures contracts are
5. Hedging with Futures. What are the disadvantages of using futures contracts to
hedge a firm’s exposure?
To use a futures contract to hedge, a firm has to put up an initial margin. Furthermore,
the futures position is marked to market on a daily basis over the life of the contract.
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 of foreign exchange at a fixed price for a specified time period. A
7. Put Contract Elements. The CME exchange-traded American put option has a
contract size of €125,000; the December puts with a strike price of 1.2900 are now
quoted at 0.0297. Explain what these figures mean for a put buyer.
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?
All currency options have three fundamental prices or rates: 1) the current spot rate;
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 being call against the writer. The writer, however, will
still experience an opportunity loss, surrendering against the option the same currency
that could have been sold for more in the open market.
From the option writer’s point of view, only two events can take place:
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?
Once an option has been purchased, the option premium is essentially a sunk cost
which no longer drives any decision-making. What matters after purchase is how the
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?
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
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 of gain that would be made if the underlying shares were
purchased today and delivered immediately against the option. Intrinsic value can be
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?
If an option could currently be exercised for a profit it is in-the-money. If the current
16. Option Pricing and the Forward Rate. What is the relationship or link between the
forward rate and the foreign currency option premium?
Because foreign currency option premiums using the current spot exchange rate and
both the domestic and foreign interest rate in their pricing, and those same three
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?
Historic volatility is the standard deviation of daily spot rates as calculated over a