Study Guide for Final Exam Know the difference of Forward and Futures Contracts their purpose and how to calculate payoff how to calculate the premium or discount o Purpose Hedge future payable Purchase a future forward or receivables sell a future forward o Payoff o Premium Discount F S 1 p where OR F S 1 p F is the forward rate S is the spot rate p is the percentage by which the forward rate exceeds the spot rate F S forward rate exhibits a discount OR F 1 F S forward rate exhibits a premium OR F 2 Know how to reverse a futures position o If a firm that buys a currency futures contract decides before the settlement date that it no longer wants to maintain its position it can close out the position by selling an identical futures contract Gain Loss difference in buying selling prices o Example On Jan 10 Disney anticipates it will need Australian dollars in March when it orders supplies from an Australian supplier Disney purchases a contract specifying A 100 000 with a March settlement date priced at 53 per A On Feb 15 Disney will not need the Australian dollar due to a reduction in production levels It sells a futures contract on A with a March settlement date to offset the the Jan contract At this time the futures contract is priced at 0 50 per A Therefore Disney incurs a loss of 3 000 from its futures positions Know currency options PUT and CALL i e what they give the investor to right to do option terminology their use the payoff function graphs as well and factors affecting the premiums o CALL Grants the right to buy currency at a designated exercise strike price Monthly expiration dates for each option If the spot rate rises above the strike price the owner of a CALL can exercise the right to buy currency at the strike price The buyer of the options pays a premium If the spot exchange rate is greater than the strike price the option is in the money If the spot rate is equal to the strike price the option is at the money If the spot rate is lower than the strike price the option is out of the money Firms use CALL options to hedge payables hedge project bidding hedge target bidding and speculation o Factors that affect the CALL Option Spot price relative to the strike price S X The higher the spot relative to the strike price the higher the option price will be Higher probability of buying the currency at a lower rate than what you could sell it for Length of time before expiration Longer time to maturity the higher the option price will be Spot rate has a greater chance of rising high above the strike price if it has a longer period of time to do so Potential variability of currency Greater the variability of the currency the higher the probability that the spot rate can rise above the strike price Higher volatile currencies have higher call options o PUT Grants the right to sell currency at a designated exercise strike price If the spot rate falls below the strike price the owner of a PUT can exercise the right to sell currency at the strike price The buyer of the options pays a premium Maximum possible loss is the premium If the spot exchange rate is lower than the strike price the option is in the money If the spot rate is equal to the strike price the option is at the money If the spot rate is greater than the strike price the option is out of the money o Factors that affect the PUT Option Spot rate of currency relative to the strike price The lower the spot rate relative to the strike price the more valuable the put option will be S X negative relationship with premium Length of time until expiration Longer the time the greater the premium Variability of the currency Greater variability the greater the premium Difference between European and American Options o Similar to American Style options except that they must be exercised on the expiration date if they are to be exercised at all o Much less flexibility Know the benefits and market expectations from such currency option combinations such as a long and short Strangles and Straddles o The names straddle and strangle may give you clues about these option positions Like your favorite politician trying to win both Democratic and Republican votes these positions are on both sides of the issue Long straddles and strangles make money if the stock price moves up or down significantly Who cares which way the stock goes so long as it GOES o Straddles and strangles are essentially speculations on whether the price of the stock will move a lot or not or implied volatility is going to go up or down If you think the stock is going to move big in one direction or another and or if you think implied volatility is going to rise you would buy a straddle or strangle If you think the stock is going to sit still or not move very much and or if you think implied volatility is going to fall you would sell short a straddle or strangle o A long straddle is long 1 call and long 1 put at the same strike price and expiration and on the same stock A long strangle is long 1 call at a higher strike and long 1 put at a lower strike in the same expiration and on the same stock Such a position makes money if the stock price moves up or down well past the strike prices of the strangle Long straddles and strangles have limited risk but unlimited profit potential o The simplest reason to buy straddles and strangles is that they manufacture long deltas if the underlying stock rallies and short deltas if the underlying stock falls Long deltas on the way up and short deltas on the way down What s the catch Straddles and strangles can be expensive to buy and if the stock price just sits there or moves very little losses can be large o A short straddle is short 1 call and short 1 put at the same strike price and expiration and on the same stock A short strangle is short 1 call at a higher strike and short 1 put at a lower strike in the same expiration and on the same stock Such a position makes money if the stock price stays at the strike of the straddle or in between the strike prices of the strangle Short straddles and strangles have unlimited risk and limited profit potential o Selling straddles and strangles can be attractive but always dangerous Just as a long straddle can lose money at an alarming rate when the stock price doesn t move at all a short straddle makes all the money in that scenario But the profits collected quickly disappear if the stock price moves too much Potential losses on short straddles and …