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CHAPTER 7 Future and Options on Foreign Exchange - Coggle Diagram
CHAPTER 7
Future and Options on Foreign Exchange
Basic Option-Pricing Relationships at Expiration
At expiry, an American call option is worth the same as a European option with the same characteristics
American Option Pricing Relationships
CaT > CeT = Max[ST - E, 0]
PaT > PeT = Max[E - ST, 0]
Can do everything that you can do with a European option and can exercise prior to expiry—this option to exercise, early has value,early has value.
European Option Pricing
Relationships
It follows that in a rational marketplace, portfolio A will be priced to sell for at least as much as portfolio B, that is: Ce + E /(1 + r$) ≥ St/(1 + ri).
Can be shown that the lower boundary pricing relationship for a European put
Recall that IRP implies FT = St[(1 + r$)/(1 + ri)]
Which in turn implies that FT/(1 + r$) = St/(1+ ri).
Futures Contracts: Some Preliminaries
Futures Contracts: Preliminaries
A futures contract is different from a forward contract:
Futures are standardized contracts trading on organized exchanges with daily
resettlement through a clearinghouse.
A futures contract is like a forward contract:
a certain currency will be exchanged for another at a specified time in the future at prices specified today.
Standardizing Features: Contract Size,Delivery Month, Daily marked-to-market
Differences between Futures and
Forward contracts
Futures contracts
Settlement: Daily settlement, or marking-to- market, done by the futures clearinghouse through the participant’s performance bond
account.
Trading location: Traded competitively on organized exchanges.
Trading Costs: Bid-ask spread plus broker’s commission.
Delivery: Delivery of the underlying asset is seldom made. Usually a reversing trade is transacted to exit the market.
Contractual Size: Standardized amount of the underlying asset.
Expiration Date: Standardized delivery da
Forward contracts
Delivery: Delivery of the underlying asset is
commonly made.
Expiration Date: Tailor-made delivery date that
meets the needs of the investor.
Trading Costs: Bid-ask spread plus indirect bank charges via compensating balance requirements.
Trading location: Traded by bank dealers via a network of telephones and computerized dealing systems.
Settlement: Participant buys or sells the contractual amount of the
underlying asset from the bank at maturity at the forward (contractual) price
Contractual Size: Tailor-made to the needs of the
participant.
Basic Currency Futures Relationships
Basic Currency Futures
Relationships
Open Interest refers to the number of contracts outstanding for a particular delivery month.
Open interest is a good proxy for demand for a contract.
Some refer to open interest as the depth of the market. The breadth of the market would be
how many different contracts (expiry month, currency) are outstanding.
Options Contracts: Some Preliminaries
Options Contracts: Some
Preliminaries
An option gives the holder the right, but not the obligation, to buy or sell a
given quantity of an asset in the future, at prices agreed upon today.
Call options gives the holder the right, but not the obligation, to buy a given quantity of
some asset at some time in the future, at prices agreed upon today.
Put options gives the holder the right, but not the obligation, to sell a given quantity of
some asset at some time in the future, at prices agreed upon today.
Glossary of terms
The investor buying the option is called the buyer or holder.
The investor selling the option is called the writer or seller.
When the holder of the option decides to buy (sell) the asset at maturity, it is said that he/she
is exercising the option.
Since the holder enjoys a privilege - the option to buy or sell - he/she must pay a premium to
acquire the option.
The asset to be bought or sold is called the underlying asset.
The price agreed upon for buying or selling the underlying asset is called exercise price or
strike price.
Options are traded on options exchanges.
❑ The number of outstanding option contracts at any time is called open interest.
Options Contracts: Some
Preliminaries
European options can only be exercised on the expiration date.
American options can be exercised at any time up to and including the expiration date.
Since this option to exercise early generally has value, American options are usually worth more than European options, other things equal.
Currency Options Markets
Option on a currency futures contract.
Exercise of a currency futures option results in a long futures position for the holder of a call or the writer of a put.
Exercise of a currency futures option results in a short futures position for the seller of a call or the buyer of a put.
If the futures position is not offset prior to its expiration, foreign currency will change
hands.
Currency Futures Markets
Others include:
The Intercontinental Exchange (ICE) Futures U.S
The Mexican Derivatives Exchange
The BM&F Exchange in Brazil
The Budapest Commodity Exchange
The Derivatives Market Division of the Korean Exchange.
The Chicago Mercantile Exchange (CME, from 1972) is by far the largest.
Expiry cycle: in a March, June, September, and December
Delivery date: the third Wednesday of the expiration month.
The last day of trading for most contracts is the second business day prior to the delivery
date.