Currency futures
Futures Contract is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. Futures contracts have secondary markets, can be traded many times during life of contract, like a bond (vs. bank loan).
A futures contract is a standardized commitment that describes the key features of a transaction:
The quantity and quality of the commodity being exchanged
The date on which the exchange is to take place
The method of delivery
The price at which the commodity will be purchased
Examples: Yen contracts: ¥12.5m (approx $116,000), Pound: £62,500 (approx. $112,500), Euro: 125,000 (approx $160,000), SF: 125,000 (approx $104,000), etc. Expiration dates: March, June, Sept, Dec. on the 3rd Wednesday.
Currency futures started trading in 1972 at the Chicago Mercantile Exchange (CME), which opened in 1898 (largest futures exchange in U.S., 4 product areas: stock indexes, interest rates, currency, commodities) Why then? Actually, trading in many derivative markets started to explode in the 70s. Why?
Fixed exchanges rates until 1973 meant no currency risk.
Interest rates were fixed by federal law for savings accounts (Reg. Q) and checking accounts (i = 0%), and some mortgages (led to "points").
Inflation was low and stable, 2-3% in the 50s, 60s and early 70s.
Interest rates on T-bills were low and stable 1-2%.
Price of oil was low and stable stable.
Economic and financial volatility increased dramatically in the 1970s. Fixed ex-rates were abandoned, started to float. Req Q was eventually repealed. Inflation and int. rates rose and became volatile in the 1970s. Oil prices doubled and tripled in the two oil shocks of the 1970s (74-75 and 79-80). Led to an explosion in the derivative markets for futures contracts.
Unlike the purchase or sale of a security, no price is paid or received upon the purchase or sale of a futures contract. Initially, the Account will be required to deposit in a custodial account an amount of cash, United States Treasury securities, or other permissible assets equal to approximately 5% of the contract amount. This amount is known as “initial margin.” The nature of initial margin in futures transactions is different from that of margin in security transactions in that futures contract margin does not involve the borrowing of funds by the customer to finance the transactions. Rather, the initial margin is in the nature of a performance bond or good faith deposit on the contract, which is returned to the Account upon termination of the futures contract assuming all contractual obligations have been satisfied.
The initial investment required to establish a futures position, usually 3-5% of the contract value. To buy one U.K. pound contract, you would have to put up about $4500 ($112,500 x 4%). You would also have to keep a "maintenance margin" usually about 75% of the initial margin. In this case, you could never let your account go below $3375 (75% of $4500). If you can't make margin call, your contract is liquidated by broker.
There are two ypes of futures contracts, those that provide for physical delivery of a particular commodity and those that call for an even tual cash settlement. The commodity itself is specifically defined, as is the month when delivery or settlement is to occur. A July futures contract, for example, provides for delivery or settlement in July.
It should be noted that even in the case of delivery-type futures contracts, very few actually result in delivery. Not many speculators want to take or make delivery of 5,000 bushels of grain or 40,000 pounds of pork. Rather, the vast majority of both speculators and hedgers choose to realize their gains or losses by buying or selling an offsetting futures contract prior to the delivery date.
Selling a contract that was previously pur chased liquidates a futures position in exactly the same way that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract that was initially sold can be liquidated by making an offsetting purchase. In either case, profit or loss is the difference between the buying price and the selling price, less transaction expenses.
Cash settlement futures contracts are precisely that, contracts that are settled in cash rather than by delivery at the time the contract expires. Stock index futures contracts, for example, are settled in cash on the basis of the index number at the close of the final day of trading.
Participants of currency futures market
Speculators - pure speculative bet/investment, with no business interest in the underlying commodity/currency.
Hedgers - someone with a business/personal interest in the underlying currency, and is using futures trading to minimize, eliminate or control currency risk, e.g., MNCs, banks, exporters, importers, etc.
If a hedger is short (long) and a speculator is long (short), the hedger is "selling" their risk to the speculator.
Hedgers
The details of hedging can be somewhat complex but the principle is simple. By buying or selling in the futures market now, individuals and firms are able to establish a known price level for something they intend to buy or sell later in the cash market. Buyers are thus able to protect themselves against—that is, hedge against—higher prices and sellers are able to hedge against lower prices. Hedgers can also use futures to lock in an acceptable margin between their purchase cost and their selling price.
A jewelry manufacturer will need to buy additional gold from its supplier in six months to produce jewelry that it is already offering in its catalog at a published price. An increase in the cost of gold could reduce or wipe out any profit margin. To minimize this risk, the manufacturer buys futures contracts for delivery of gold in six months at a price of $300 an ounce.
If, six months later, the cash market price of gold has risen to $320, the manufacturer will have to pay that amount to its supplier to acquire gold. But the $20 an ounce price increase will be offset by a $20 an ounce profit if the futures contract bought at a price of $300 is sold for $320.
The hedge, in affect, provided protection against an increase in the cost of gold. It locked in a cost of $300, regardless of what happened to the cash market price. Had the price of gold declined, the hedger would have incurred a loss on the futures position but this would have been offset by the lower cost of acquiring gold in the cash market.
Whatever the hedging strategy, the common denominator is that hedgers are willing to give up the opportunity to benefit from favorable price changes in order to achieve protection against
unfavorable price changes.
Forex option is a contract that conveys the right, but not the obligation, to buy or sell a particular item at a certain price for a limited time. Only the seller of the option is obligated to perform.
Simply stated, a buyer of a currency option acquires the right - but not the obligation - to buy (a “call”) or sell (a “put”) a specific amount of one currency for another at a predetermined price and date in the future. The cost of the option is called a ‘premium’ and is paid by the buyer to the seller. The seller determines the price of the premium at which they are willing to grant the option, based on current rates, nominated delivery and expiry dates, the nominated strike rate and option style.
It is entirely up to the buyer whether or not to exercise that right; only the seller of the option is obligated to perform.
Call option
Call Option - an option to BUY an underlying asset (stock or currency) at an agreed upon price (Strike Price or Exercise Price) on or before the expiration date. Since this option has economic value, you have to pay a price, called the Premium.
Example: Microsoft (MSFT) was recently selling at $29.50/share, and there were 4 different options. For example, for $1.00 (premium) you could buy one call option that would allow you to buy a share of MSFT for $30 (strike P) on or before January 16, 2005. You will exercise the option if P > $30, and you will make money if the P > $31.00 ($30 + $1.00). If P = $30, you will not exercise the option, it will expire worthless and you will lose the premium ($1.50).
Next example shows two ways to calculate profit from call option:
You have paid a premium of $187.50 in July that gives you the right to buy SF @ $0.67 on or before September 10. If the SF sells at $.7025 on expiration, you can exercise your right to buy @$0.67 and then sell at $0.7025, for proceeds of $2,031.25. Subtracting the cost of your option premium of $187.50, you have a net profit of $1,843.75 ($2,031.25 - $187.50). The writer (seller) of the call option would lose $1,843.75.
Profit = S - (Exercise Price + Premium) x SF62,500
Profit = $.7025 - ($0.670 + $0.003) = $0.0295/SF x SF62,500 = $1,843.75
Profit = (S - Exercise Price) x SF62,500 - PREMIUM
Profit = ($0.7025 - $0.67) x SF62,500 = $2,031.25 - $187.50 = $1,843.75
ROI: Your return on investment (ROI) would be $1843.75 / $187.50 (Profit / Investment) = 983% for 2 months! Illustrates leverage. You control about $42,000 worth of SFs (SF62,500 x $.67/SF) with only $187.50, or less than 1% of the underlying value of the currency.
If spot rate at expiration is only $.6607/SF (or any rate < $.67/SF), the option expires worthless, you lose the premium of $187.50, which would be the gain to the writer (seller) of the call.
Note: If the spot rate was between $.67 and $.673, you would exercise, but lose money. For example, if S = $0.671, you would lose ($.671 - .673) x SF62,500 = -$125 by exercising, vs. -$187.50 without exercising.
Like futures trading, option trading is a zero-sum game. The buyer of the option purchases it from the seller or the person who "writes" the call. Options are traded in units of 100 shares.
Put option
Put Option - gives the owner the right, but not the obligation to sell an underlying asset at a stated price on or before the expiration date.
Example: MSFT $30 January 2005 puts were selling for $2 (premium). You will make money if the P < $28. You will exercise if P < $30, exercise but lose money if P $28-30. If P > $30, put will expire worthless.
The option extends only until the expiration date. The rate at which one currency can be purchased or sold is one of the terms of the option and is called the exercise price or strike price. The total description of a currency option includes the underlying currencies, the contract size, the expiration date, the exercise price and another important detail: that is whether the option is an option to purchase the underlying currency - a call - or an option to sell the underlying currency - a put.
A Currency Option is a bilateral contract between two counterparties, and therefore each party is responsible for assessing the credit standing and capacity of the other party, before entering into a transaction.
There are two types of option expirations - American-style and European-style. American-style options can be exercised on any business day prior to the expiration date. European-style options can be exercised at expiration only.
Currency options give the holder the right, but not the obligation, to buy or sell a fixed amount of foreign currency at a specified price. 'American' options are exercisable at any time prior to the expiration date, while 'European' options are exercisable only on the expiration date. Most currency options have 'American' exercise features. Call options give the holder the right to buy foreign currency, while put options give the holder the right to sell foreign currency.
Call options make money when the exchange rate rises above the exercise price (allowing the holder to buy foreign currency at a lower rate), while put options make money when the exchange rate falls below the exercise price (allowing the holder to sell foreign currency at a higher rate). If the exchange rate doesn't reach a level at which the option makes money prior to expiration, it expires worthless – unlike forwards and futures, the holder of an option does not have an obligation to buy or sell if it is not advantageous to do so.
Other types of currency options:
Average Rate Option
Unlike a conventional option, which is settled by comparing the strike with the spot rate at expiration, an average rate option is settled by comparing the strike with the average of the spot rate over the option period. This hedges against price movements without locking in a fixed price or rate upfront. The average can be geometric or arithmetic and can begin at any point during the option period. The sampling process frequency and interval of underlying price observations can be tailored to suit the user.
Unlike a straight American or European-style option, an average rate option can be settled more than once over its life. So for example, the holder of a one-year average rate option can choose to settle the option monthly versus the average price or rate of the underlying the previous month. Average rate options are cheaper than conventional options because the averaging process smooths out the underlying price movements thereby reducing volatility and hence the premium of the option. Typically the volatility of an average rate option is about half the volatility of a conventional option. Also known as an Average Price or Asian option. Averaging has been applied to a wide range of swaps and options.
Average Strike Option
An Average strike option is similar to a standard option except that the strike price is taken to be the arithmetic average of the price of the underlying asset during the life of the option.
Currency options were originally traded OTC (dealer network), not on organized exchanges. Currency traders were intl. banks, investment banks, brokerage houses.
Options in OTC can be customized for the traders - maturity, contract size, exercise price, usually in large amounts of $1m, the size of most currency trades in the spot market.
Since 1982, currency options have been traded on the Philadelphia Stock Exchange, see Exhibit 9.6 on p. 210 for contracts. Option contract sizes are half of the futures contracts, e.g., £31,250 instead of £62,500, approx $56,000. Contracts are traded on a March, June, Sept, Dec cycle with original maturities of 3, 6, 9, 12 months. In addition, one and two month contracts are also traded so that there are always 1, 2 and 3 month contracts. Also, long term option contracts are traded for 18, 24, 30, 36 months.
OTC trading dominates currency options trading on the Philadelphia exchange, $60B/day OTC vs. $1.5B/day for exchange-traded contracts. See WSJ story on p. 211. Big currency traders (banks) prefer OTC market, it operates 24 hours/day (necessary now in global market - time zone differences in Asia, Europe/currency crises), contract size is much bigger ($1m vs. $45,000 avg. PHLX), more efficient, lower transactions cost. PHLX limits traders to 100,000 max contracts. Also, trading is thin in exchange-traded currency derivative markets (3% of worldwide total), so prices tend to be less reliable, more volatile. For a $100m trade, it would be cheaper OTC vs. exchange trade.
