Slide 0Primary vs. Derivative Products(Currency) Futures Contracts: PreliminariesFutures Contracts: PreliminariesDaily Settlement: An ExampleSlide 6Slide 7Performance Bond MoneySlide 9Toting UpCurrency Futures MarketsThe Chicago Mercantile ExchangeCME After HoursReading Currency Futures Quotes, 2/10/11Basic Currency Futures RelationshipsSlide 16Slide 17Reading Currency Futures Quotes, 2/10Eurodollar Interest Rate Futures ContractsReading Eurodollar Futures Quotes, 2/10/11Trading irregularitiesMoney Laundering: Hillary Clinton’s Cattle FuturesOptions Contracts: PreliminariesSlide 24Slide 25Slide 26Currency Options MarketsPHLX Currency Option SpecificationsCall Option Pricing Relationships at ExpiryPut Option Pricing Relationships at ExpiryBasic Option Profit ProfilesSlide 32Slide 33Slide 34ExampleSlide 36Slide 37American Option Pricing RelationshipsMarket Value, Time Value and Intrinsic Value for an European Call at tEuropean Call Option Pricing relationship (determine the call price using the “rep” portfolio & no arbitrage. e.g., $1.1 for $2-B, $1.4 for $3-R, what about $2-B & $6-R? )European Call Option Pricing RelationshipsEuropean Put Option Pricing RelationshipsA Brief Review of CIRPBinomial Call Option Pricing ModelBinomial Option Pricing ModelSlide 46Slide 47Slide 48Slide 49Slide 50Slide 51The Hedge RatioHedge RatioCreating a Riskless HedgeSlide 55Replicating Portfolio Call on €10,000 K = $1.50/€Risk Neutral Valuation of OptionsSlide 58Slide 59Slide 60Test Your IntuitionTest Your Intuition (continued)Slide 63Slide 64Take-Away LessonsFinding Risk Neutral ProbabilitiesCurrency Futures OptionsSlide 68Binomial Futures Option PricingSlide 70Slide 71Option PricingHedging a Call Using the Spot MarketSlide 74Hedging a Put Using the Spot MarketSlide 76Hedging a Call Using FuturesHedging a Put Using Futures2-Period OptionsChapter Objective:This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures.7Chapter SevenFutures and Options on Foreign Exchange7-1Primary vs. Derivative ProductsPrimary Financial Products: their values are determined by their own cash flows. E.g., stocks, bonds, currencies, (real, financial, and artificial) commodities, etcDerivative Products (Derivatives, Contingent Claims): their values are derived from the value of the underlying primary security. E.g., forward, futures, options, swaps, insurance products, etc.(Currency) Futures Contracts: PreliminariesA futures contract is like a forward contract:It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today.A futures contract is different from a forward contract:Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.7-3Futures Contracts: PreliminariesStandardizing Features:CFTCContract size ~ originally determined around $100kDelivery months ~ 3, 6, 9, 12Daily settlement (mark to market)Trading costs ~ commissions for a round trip A daily price limitInitial performance bond (=initial margin, about 2 percent of contract value, cash or T-bills held in a street name at your brokerage).7-4Daily Settlement: An ExampleConsider a long position in the CME EUR/USD contract.It is written on €125,000 and quoted in $ per €.The strike price is $1.30 the maturity is 3 months.At initiation of the contract, the long posts an initial performance bond of $1,350.The maintenance performance bond is $1,000.7-5Daily Settlement: An ExampleRecall that an investor with a long position gains from increases in the price of the underlying asset.Our investor has agreed to BUY €125,000 at $1.30 per euro in three months time.With a forward contract, at the end of three months, if the euro was worth $1.24, he would lose $7,500 = ($1.24 – $1.30) × 125,000.If instead at maturity the euro was worth $1.35, the counterparty to his forward contract would pay him $6,250 = ($1.35 – $1.30) × 125,000.7-6Daily Settlement: An ExampleWith futures, we have daily settlement of gains an losses rather than one big settlement at maturity.Every trading day:if the price goes down, the long pays the shortif the price goes up, the short pays the long=> A zero-sum game!After the daily settlement, each party has a new contract at the new price with one-day-shorter maturity.7-7Performance Bond MoneyEach day’s losses are subtracted from the investor’s account.Each day’s gains are added to the account.In this example, at initiation the long posts an initial performance bond of $1,350.The maintenance level is $1,000.If this investor loses more than $350 he has a decision to make: he can maintain his long position only by adding more funds—if he fails to do so, his position will be closed out with an offsetting short position.7-8Daily Settlement: An ExampleOver the first 3 days, the euro strengthens then depreciates in dollar terms (with $1,500 initial balance):$1,250–$1,250$1.31$1.30$1.29–$1,250Gain/LossSettle= ($1.31 – $1.30)×125,000$2,750$1,500 = $1,750 - $1,250 $250Account Balance= $1,500 + $1,250On third day suppose our investor keeps his long position open by posting an additional $1,100 at minimum to achieve the initial margin requirement of $1,350. Otherwise, his account will be closed out with $250 left for him. A total cost of $1,250 from $1,500 initial balance.= $1,500 - $1,250 7-9Toting Up At the end of the 3rd day, our investor has three ways of computing his gains and losses:Sum of daily gains and losses– $1,250 = $1,250 – $1,250 – $1,250 Contract size times the difference between initial contract price and last settlement price. – $1,250 = ($1.29/€ – $1.30/€) × €125,000Ending balance on account minus beginning balance on account, adjusted for deposits or withdrawals. – $1, 250 = $250 - $1,5007-10Currency Futures MarketsThe Chicago Mercantile Exchange (CME) is by far the largest. Others include:The Philadelphia Board of Trade (PBOT)The MidAmerica Commodities ExchangeThe Tokyo International Financial Futures ExchangeThe London International Financial Futures Exchange7-11The Chicago Mercantile ExchangeExpiry cycle: March, June, September, December.Delivery date third Wednesday of delivery month.Last trading day is the second business day preceding the delivery day.CME