CHAPTER 7 Futures and Options on Foreign Exchange

CHAPTER 7 Futures and Options on Foreign Exchange

Futures Contracts: Some Preliminaries

Currency Futures Markets

International Finance in Practice:

CME Ramping Up FOREX Support, Targets OTC Business

Basic Currency Futures Relationships

Eurodollar Interest Rate Futures Contracts

Options Contracts: Some Preliminaries

Currency Options Markets

Currency Futures Options

Basic Option-Pricing Relationships at Expiration

American Option-Pricing Relationships

European Option-Pricing Relationships

Binomial Option-Pricing Model

European Option- Pricing Formula

Empirical Tests of Currency Options

Summary

MINI CASE:

The Options Speculator

Futures Contracts: Some Preliminaries

1

A CME contract on ?125,000 with September delivery

a)

Is an example of a forward contract

b)

Is an example of a futures contract

c)

Is an example of a put option

d)

Is an example of a call option

Answer: b)

Rationale: options trade on the CBOE

2

Yesterday, you entered into a futures contract

to buy ?62,500 at $$1.20 per ?.

Suppose

that the futures price closes today at $$1.16. How much have you made/lost?

a)

Depends on your margin balance

b)

You have made $$2,500.00

c)

You have lost $$2,500.00

d)

You have neither made nor lost money, yet.

Answer: c)

Rationale: You have lost $$0.04, 62,500 times for a total loss of $$2,500 = $$0.04

/?

×

?

62,500

3

In reference to the futures

market, a ―speculator‖

a)

attempts to profit from a change in the futures price

b)

wants

to

avoid

price

variation

by

locking

in

a

purchase

price

of

the

underlying

asset

through

a

long

position

in

the

futures

contract

or

a

sales

price

through

a

short position in the futures contract

c)

stands ready to buy or sell contracts in unlimited quantity

d)

b) and c)

Answer: a)

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4

Comparing

―forward‖ and ―futures‖ exchange contracts, we can say that:

a)

T

hey are both ―marked

-to-

market‖ daily

.

b)

Their

major

difference

is

in

the

way

the

underlying

asset

is

priced

for

future

purchase or sale: futures settle daily and forwards settle at maturity.

c)

A futures contract is negotiated by open outcry between floor brokers or traders

and is traded on organized exchanges, while forward contract is tailor-made by an

international bank for its clients and is traded OTC.

d)

b) and c)

Answer: d)

5

Comparing

―forward‖ and ―futures‖ exchange contracts, we can say that

a)

Delivery of the underlying asset is seldom made in futures contracts

b)

Delivery of the underlying asset is usually made in forward contracts

c)

Delivery

of

the

underlying

asset

is

seldom

made

in

either

contract

—

they

are

typically cash settled at maturity.

d)

a) and b)

e)

a) and c).

Answer: d)

6

In which market does a clearinghouse serve as a third party to all transactions?

a)

Futures

b)

Forwards

c)

Swaps

d)

None of the above

Answer: a)

7

In the event of a default on one side of a futures trade,

a)

The clearing member stands in for the defaulting party

b)

The clearing member will seek restitution for the defaulting party

c)

If the default is on the short side, a randomly selected long contract will not get

paid. That party will then have standing to initiate a civil suit against the

defaulting short.

d)

a) and b)

Answer: d)

8

Yesterday, you entered into a futures contract

to buy ?62,500 at $$1.20 per ?. Your

initial performance bond is $$1,500 and your maintenance level is $$500. At what settle

price will you get a demand for additional funds to be posted?

a)

$$1.2160 per ?.

b)

$$1.208 per ?.

c)

$$1.1920 per ?

.

d)

$$1.1840 per ?.

Answer: d)

Rationale: To get a margin call, you have to lose $$1,000. That will happen when the price

FALLS (since you’re buying euro) to $$1.1840 per ?:

[

$$1.20/ ? –

$$1.1840 per ?] × ?62,500 = $$1,000.

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77

9

Yesterday, you entered into a futures contract

to sell ?62,500 at $$1.20 per ?. Your

initial performance bond is $$1,500 and your maintenance level is $$500. At what settle

price will you get a demand for additional funds to be posted?

a)

$$1.2160 per ?.

b)

$$1.208 per ?.

c)

$$1.1920 per ?.

d)

$$1.1840 per ?.

Answer: a)

Rationale: To get a margin call, you have to lose $$1,000. That will happen when the price

RISES (since you’re selling euro at $$1.20 per ?.

) to

$$1.2160 per ?:

[

$$1.2160/ ? –

$$1.20 per ?] × ?62,500 = $$1,000.

10

Three days ago, you entered into a futures contract

to sell ?62,500 at $$1.20 per ?.

Over the past three days the contract has settled at $$1.20, $$1.22, and $$1.24. How

much have you made or lost?

a)

Lost $$0.04 per ? or $$2,500

b)

Made $$0.04 per ? or $$2,500

c)

Lost $$0.06 per ? or $$3,750

d)

None of the above

Answer: a)

Rationale: Losses will happen when the price RISES (since you’re selling euro at

$$1.20

per ?.

)

Total loss

[

$$1.20/ ? –

$$1.24 per ?] × ?62,500 = –

$$2,500

Currency Futures Markets

11

Today’s

settlement

price

on

a

Chicago

Mercantile

Exchange

(CME)

Yen

fut

ures

contract is $$0.8011/?

100.

Your margin account currently has a balance of $$2,000.

The

next

three

days’

settlement

prices

are

$$0.8057/?100,

$$0.7996/?100,

and

$$0.7985/?

100.

(The contractual size of one CME Yen contract is ?

12,500,000). If

you have a short position in one futures contract, the changes in the margin account

from daily marking-to-market will result in the balance of the margin account after

the third day to be

a)

$$1,425

b)

$$2,000

c)

$$2,325

d)

$$3,425

Answer: c) not unlike Problem 1 at the end-of-chapter exercises

Rationale: $$2,325 = $$2,000 +

?

< br>12,500,000×

[(0.008011

–

0.008057) + (0.008057

–

0.007996) + (0.007996

–

0.007985)]

Please note that $$0.8011/?

100 = $$0.008011/?

and $$0.8057/?

100 = $$0.008057/?

, etc.

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78

12

Today’s

settlement

price

on

a

Chicago

Mercan

tile

Exchange

(CME)

Yen

futures

contract is $$0.8011/?

100.

Your margin account currently has a balance of $$2,000.

The

next

three

days’

settlement

prices

are

$$0.8057/?100,

$$0.7996/?100,

and

$$0.7985/?

100.

(The contractual size of one CME Yen contract is ?

12,500,000). If

you have a long position in one futures contract, the changes in the margin account

from daily marking-to-market, will result in the balance of the margin account after

the third day to be:

a)

$$1,425

b)

$$1,675

c)

$$2,000

d)

$$3,425

Answer: b) not unlike Problem 1 at the end-of-chapter exercises

Rationale: $$1,675 = $$2,000 +

?

12,500,000×

[(0.008057 - 0.008011) + (0.007996

–

0.008057) + (0.007985

–

0.007996)]

Please note that $$0.8011/?

100 = $$0.008011/?

and $$0.8057/?

100 = $$0.008057/?

, etc.

Basic Currency Futures Relationships

13

Open interest in currency futures contracts

a)

Tends to be greatest for the near-term contracts

b)

Tends to be greatest for the longer- term contracts

c)

Typically decreases with the term to maturity of most futures contracts

d)

a) and c)

Answer: a)

14

The ―open interest‖ shown in currency futures quotations is:

a)

the total number of people indicating interest in buying the contracts in the near

future

b)

the total number of people indicating interest in selling the contracts in the near

future

c)

the total number of people indicating interest in buying or selling the contracts in

the near future

d)

the total number of long or short contracts outstanding for the particular delivery

month

Answer: d)

Eurodollar Interest Rate Futures Contracts

15

The most widely used futures contract for hedging short-term U.S. dollar interest rate

risk is:

a)

The Eurodollar contract

b)

The Euroyen contract

c)

The EURIBOR contract

d)

None of the above

Answer: a)

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79

16

Consider the position of a treasurer of a MNC, who has $$20,000,000 that his firm will

not need for the next 90 days:

a)

He could borrow the $$20,000,000 in the money market

b)

He could take a long position in the Eurodollar futures contract.

c)

He could take a short position in the Eurodollar futures contract

d)

None of the above

Answer: b)

17

A

DECREASE

in

the

implied

three-month

LIBOR

yield

causes

Eurodollar

futures

price

a)

To increase

b)

To decrease

c)

There is no direct or indirect relationship

d)

None of the above

Answer: a)

Options Contracts: Some Preliminaries

18

If you think that the dollar is going to appreciate against the euro

a)

You should buy put options on the euro

b)

You should sell call options on the euro

c)

You should buy call options on the euro

d)

None of the above

Answer: c)

19

From the perspective of the writer of a put

option written on ?62,500.

If the str

ike

price is $$1.25/?, and the option premium is $$1,875, at

what exchange rate do you

start to lose money?

a)

$$1.22/?

b)

$$1.25/?

c)

$$1.28/?

d)

None of the above

Answer: a)

Rationale: Per euro, the option premium is

$$1,875< /p>

?62,500

?

$$0.03/

?

. Since it’s a put option,

the

writer

loses

money

when

the

price

goes

down,

thus

he

breaks

even

at

$$1.25/?

–

$$0.03/? = $$1.22/?

20

A European option is different from an American option in that

a)

One is traded in Europe and one in traded in the United States

b)

European

options

can

only

be

exercised

at

maturity;

American

options

can

be

exercised prior to maturity.

c)

European options tend to be worth more than American options,

ceteris paribus.

d)

American options have a fixed exercise price; European options’ exercise price is

set at the average price of the underlying asset during the life of the option.

Answer: b)

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80

21

An ―option‖ is:

a)

a contract giving the seller (writer) the right, but not the obligation, to buy or sell

a given quantity of an asset at a specified price at some time in the future

b)

a contract giving the owner (buyer) the right, but not the obligation, to buy or sell

a given quantity of an asset at a specified price at some time in the future

c)

not a derivative, nor a contingent claim, security

d)

unlike a futures or forward contract

Answer: b)

22

An investor believes that the price of a stock, say IBM’s shares, will increase in the

next

60

days.

If

the

investor

is

correct,

which

combination

of

the

following

investment strategies will show a profit in all the choices?

(i) - buy the stock and hold it for 60 days

(ii) - buy a put option

(iii) - sell (write) a call option

(iv) - buy a call option

(v) - sell (write) a put option

a)

(i), (ii), and (iii)

b)

(i), (ii), and (iv)

c)

(i), (iv), and (v)

d)

(ii) and (iii)

Answer: c)

Currency Options Markets

23

Most exchange traded currency options

a)

Mature every month, with daily resettlement.

b)

Have original maturities of 1, 2, and 3 years.

c)

Have original maturities of 3, 6, 9, and 12 months.

d)

Mature every month, withOUT daily resettlement

Answer: c)

24

The volume of OTC currency options trading is

a)

Much smaller than that of organized-exchange currency option trading.

b)

Much larger than that of organized-exchange currency option trading.

c)

Larger,

because

the

exchanges

are

only

repackaging

OTC

options

for

their

customers

d)

None of the above

Answer: b)

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81

25

In

the

CURRENCY

TRADING

section

of

The

Wall

Street

Journal

,

the

following

appeared under the heading OPTIONS:

Philadelphia Exchange

Puts

Swiss Franc

69.33

62,500 Swiss Francs-cents per unit

Vol.

Last

68

May

1

2

0.30

69

May

5

0

0.50

Which combination of the following statements are true?

(i)- The time values of the 68 May and 69 May put options are respectively .30

cents and .50 cents.

(ii)- The 68 May put option has a lower time value (price) than the 69 May put

option.

(iii)- If everything else is kept constant, the spot price and the put premium are

inversely related.

(iv)- The time values of the 68 May and 69 May put options are, respectively,

1.63 cents and 0.83 cents.

(v)- If everything else is kept constant, the strike price and the put premium are

inversely related.

a)

(i),

(ii), and (iii)

b)

(ii), (iii), and

(iv)

c)

(iii) and (iv)

d)

( iv) and (v)

Answer: a)

Rationale:

Premium - Intrinsic Value =

Time Value

68 May Put:

0.30

–

Max[68 - 69.33, 0] = 0.30 cents

69 May Put:

0.50

–

Max[69 - 69.33, 0] = 0.50 cents

Currency Futures Options

26

With currency futures options the underlying asset is

a)

Foreign currency

b)

A call or put option written on foreign currency

c)

A futures contract on the foreign currency

d)

None of the above

Answer: c)

27

Exercise of a currency futures option results in

a)

A long futures position for the call buyer or put writer

b)

A short futures position for the call buyer or put writer

c)

A long futures position for the put buyer or call writer

d)

A short futures position for the call buyer or put buyer

Answer: a)

28

A

currency

futures

option

amounts

to

a

derivative

on

a

derivative.

Why

would

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