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CHAPTER 9 - CURRENCY FUTURES AND OPTIONS

Opening story of Barings, oldest bank in UK, got in big trouble when one of its traders made took unauthorized positions in options/futures contracts. Losses were close to $1B, exceeding the bank's entire equity capital, forcing bank into "administration" by the Bank of England (UK's central bank).

Illustrates the extreme danger/volatility of derivatives. Options and futures can be used to reduce/manage/hedge risk, like insurance, but can also be extremely speculative. Why??

MECHANICS OF FUTURES CONTRACTS

Differences/similarities between futures and forward contracts, see summary Exhibit 9.1 on p. 202:

Similarities:
1. Both are derivative securities for future delivery/receipt. Agree on P and Q today for future settlement in 1 week to 10 years.
2. Both are used to hedge currency risk, interest rate risk or commodity price risk.
3. In principal they are very similar, used to accomplish the same goal of risk management.

Differences:
1. Forward contracts are private, customized contracts between a bank and its clients (MNCs, exporters, importers, etc.) depending on the client's needs. There is no secondary market for forward contracts since it is a private contractual agreement, like most bank loans (vs. bond).

2. Forward contracts are settled at expiration, futures contracts are continually settled, daily settlement.

3. Most (90%) of forward contracts are settled with delivery/receipt of the asset. Most futures contracts (99%) are settled with cash, NOT the commodity/asset.

4. Futures markets have daily price limits.

FUTURES CONTRACTS

Currency Futures Contracts are standardized contracts, with fixed, standardized contract sizes and fixed expiration dates, that are exchange-traded, i.e., traded as securities on organized exchanges. Futures contracts have secondary markets, can be traded many times during life of contract, like a bond (vs. bank loan).

Examples: Yen contracts: ¥12.5m (approx $106,000), Pound: £62,500 (approx $100,000), Euro: 125,000 (approx $140,000), SF: 125,000 (approx $90,000), etc. Expiration dates: March, June, Sept, Dec. on the 3rd Wednesday.

If you wanted to hedge receipt/payment of £100,000, you would have to either do a partial hedge of £62,500 (1 contract) or "over-hedge" with 2 contracts for £125,000 total.

Initial Margin: The initial investment required to establish a futures position, usually 3-5% of the contract value. To buy one UK pound contract, you would have to put up about $4000 ($100,000 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 $3000 (75% of $4000). If you can't make margin call, your contract is liquidated by broker.

Daily settlement (marked-to-market): Futures contracts are revalued daily depending on the daily settlement price (ex-rate). Current June pound futures are trading at about $1.61/pound. Every futures contract involves a buyer (long) and a seller (short). Buyer (seller) will gain (lose) when the settlement price rises (falls). Futures trading is a "zero-sum" game, every gain is exactly offset by a loss of the same amount. See Exhibit 9.4, p. 207.

If the CD rises (falls), the buyer/long will have their margin account increased (decreased). If the CD falls (rises), the seller/short will have their account increased (decreased).

Difference: profits/losses for a futures contract accumulate on a daily basis vs. forward contract, where profits/losses are realized all at once at contract expiration.

TWO PARTICIPANTS IN FUTURES

1. Speculators - pure speculative bet/investment, with no business interest in the underlying commodity/currency.

2. 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.

In forward contracts, 90% of settlements involve an actual exchange of assets, the short (seller) delivers the asset to the buyer (long). Examples: the bank sells DM to the U.S. importer at an agreed upon rate, so the importer can pay for merchandise. Or the bank buys Yen from the exporter at an agreed upon rate, so the exporter can convert foreign exchange into US dollars.

In futures contracts, only 1% of contracts are settled with the underlying asset, 99% are "settled with cash" by a "reversing trade." Because of daily settlement, the contract is actually settled in cash continually throughout the contract. Like buying insurance, you get a cash settlement from your auto insurance company, not a new car or body work. Futures contracts are like "side bets." 90% of forward contracts involve an exchange of currency, the person who is short (seller) actually delivers FX to the long (buyer).

Example: Exporter agrees to ship merchandise, receive €10m in 6 months. Worried? € falling. Position? Short, lock in. Two scenarios:

1. Euro depreciates over next 6 months, and exporter makes a profit in futures market on the short position. Exporter gets paid the €10m which have depreciated, sells € in spot market at a "loss," but the gain in the futures contract offsets the currency loss.

2. Euro appreciates over next 6 months, and exporter loses money in futures market. Exporter receives stronger Euros for the merchandise, sells for more dollars than expected, which is offset by the loss in futures.

Either way, the exporter is insured against currency risk, receives a guaranteed or fixed amount of dollars for the Euros in six months. No worry, insurance, the ex-rate is locked.

Reversing Trade involves taking an offsetting position, which closes out, neutralizes, your futures position. If you are long (buy), you take a short (sell) position to close out - you are then selling to yourself, neutralizes your contract.

Since currency futures contract expire on only four days per year (third Wed. in Mar, June, Sept, Dec), reversing trades allows a hedger to time their own expiration of the contract to coincide with the underlying business activity - e.g. exporting, importing.

Commission: As low as $15 per currency futures contract, which includes starting and ending the position, "round-trip" commission. Reversing trade is included.

Futures exchanges act as third party "clearinghouses" to facilitate futures trading. Buyers and sellers trade through the clearinghouse as a third party, and do not have to deal directly with each other. Traders do not then have to evaluate the creditworthiness of the other party to the transactions. The Clearing Members guarantee the trades, monitor and maintain the margin accounts, and individual traders are protected from default.

Daily Price Limit - feature of Futures, not Forward contracts. "Circuit breaker" to limit large losses in one day, set by the exchange. If the settlement price changes by the daily price limit, trading is stopped until the next day.

CURRENCY FUTURES MARKETS

Currency futures started trading in 1972 at the Chicago Mercantile Exchange (CME), which started 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?

1. Fixed exchanges rates until 1973 meant no currency risk.
2. Interest rates were fixed by federal law for savings accounts (Reg. Q) and checking accounts (i = 0%), and some mortgages (led to "points").
3. Inflation was low and stable, 2-3% in the 50s, 60s and early 70s.
4. Interest rates on T-bills were low and stable 1-2%.
5. 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.

See Exhibit 9.2 on page 229 for a description of currency contracts - contract size and exchanges - Chicago and Philadelphia (PBOT, started currency futures in 1986). Recent changes: Euro, Real, and many cross-rate contracts are now available for Euro vs. BP, Yen and SF (14 cross-rate contracts). See WSJ handout and CME website: http://www.cme.com/prd/fx/index.html. At CME, currency futures are traded daily (M-F) from 7:20 a.m. to 2 p.m. Currency futures also trade on CME's GLOBEX electronic trading system (introduced in 1992), almost 24-7. Most currency futures contracts start trading on GLOBEX at 5pm (5:30 on Sundays) and go until 4pm the next day, one hour closing for scheduled daily maintenance. Almost all CME products now trade on GLOBEX. Currency option contracts start trading on GLOBEX at 2:30pm, but then stop trading at 7:05 a.m. while CME is open. See GLOBEX schedule here: http://www.cme.com/trd/calhrs/tradehours3497.html.

Currency futures also traded at the Financial Exchange in NYC, Mexico, Brazil, Budapest and Korea.

CURRENCY FUTURES RELATIONSHIPS

See the inside back cover and Exhibit 9.3 on p. 205 to understand how currency contracts are reported at CME. Contracts are always stated in American terms, with the $ on top, i.e. $/¥, $/€, $/£, etc. Reason: Long position is always the buyer, short position is always the seller, and you are always going long (buying ¥) or short (selling ¥) on the FOREIGN CURRENCY, not the USD ($). When the Yen gets stronger (weaker), the ex-rate gets larger (smaller). Prices quoted are Open, High, Low, Settle, Change (from open to settle/close), Lifetime High and Low, and the Open Interest. Notice for Yen, it is quoted as $ per yen (.00). Reason: S ≈ ¥118/$, and therefore S = $0.008475/¥, so they multiply x 100, and it would be quoted as $.8475/¥100.

Open Interest: The number of outstanding contracts (long and short), a measure of demand. Most interest is in the nearby contract, the one expiring next (September). However, as we got closer to expiration, (Sept 18, 2002), open interest would approach zero, as traders took reversing trades to close out positions.

See Example 9.1, p. 230 - Reading Futures Quotations:

Dec. 2002 C$ (CD) futures opened at $.6370/CD, settled at $.6336. From the Change column, we know that Price fell -$.0051 from the previous day (.6887 to .6336), = 100,000CD x $-.0051/CD = $510. Daily settlement, marked-to-market would mean that the shorts (longs) would have $510 added to (subtracted from) their account. Lifetime High ($0.662) and Low ($.6190) for the Dec 2002 contract, Open Interest (8,472 contracts outstanding).

Note that the same pattern emerges in both the forward market and the futures markets for the CD, it is expected to appreciate, US $ depreciates, see Exhibit 4.4 on p. 80 for forward ex-rates. Even though the mechanics of the forward and futures markets are slightly different, they are both efficient markets for determining the expected future value of currency.

                  Forward    Futures (not exactly 30, 90, 180 days)
30 days       $.6350        $.6355
90 days        .6337          .6336
180 days      .6315          .6317

Example 9.2 on p. 206. Suppose a speculator takes a position on August 19 at $.6336/CD and that the actual spot ex-rate in Dec 2002 turns out to be $.62/CD. The profit/loss would be ($.6336/CD - $.6200/CD) x CD100,000 = $1360 gain or ($1360) loss. Since the CD depreciated by more than expected (see Exhibit 9.4), the short would gain $1360 and the long would lose $1360. Actually, the profits/losses would accumulate continually during the four months, $1360 would be the net gain/loss during the holding period.

The buyer (long) has agreed to buy 100,000 CDs for $63,360 but can only sell them in Dec at the spot rate for $62,000, loss of $1360.

The seller (short) has agreed to sell 100,000 CDs for $63,360 and can buy them at the spot rate for $62,000, profit of $1360.

What if the ex-rate turns outs to be $.65/CD in Dec 2002? Then the long profits (.65 - .6336) x CD100,000 = $1640 and the short loses $1640. For hedgers, they have locked into the $.6336/CD ex-rate and can either buy CD or sell CD at that fixed, guaranteed rate.

EURODOLLAR INTEREST RATE FUTURES

Almost 50% of all futures contracts are for debt (bond) contracts, indicating that the risk most often hedged is interest rate risk. One of the most popular futures contract is the Eurodollar Futures contract, see Exhibit 9.5, close to 7m outstanding contracts presently, out to June 2010-. Remember previous example of a bank exposed to interest rate risk because the maturity of loans > maturity of deposits. Worried about interest rates rising.

Eurodollar futures contracts are for $1m on 90 day LIBOR interest rates for CDs, for March, June, Sept and Dec expiration. Contracts are settled in cash, no actual bank CDs. Prices (F) are stated as F = 100 - LIBOR (3 mo).

Example 9.3, p. 232, prices are quoted as of Aug 20, 2002. For June 2003, ten months in the future, LIBOR is expected to be 2.36%, resulting in a settle price for June 2003 futures contracts (F) of 97.64 (100 - 2.36). Contracts are used to hedge against interest rate risk (or speculate). If you are worried about int. rates falling (rising) as a lender/saver/investor (borrower), you go LONG (SHORT) on Eurodollar futures PRICES. That is, to hedge interest rate risk, you take a position and either go long, or go short, on the PRICE of Eurodollar deposits.

Minimum price change is 1 basis point (BP), which is .0001 or .01%. 100 basis points = 1%. In the case of the June 03 contract, the change was -3 BPs or -.03% in the yield, and the price went up by 3BPs or .03%. Note that since the price is quoted as points of 100%, and the formula is F = 100 - LIBOR, the change in BP affects the price and yield by the same amount. 1BP (.01%) x $1m = $100 annually, so for 90 day LIBOR it would be $25 price change.

Example 9.4 of Eurodollar Futures Hedge: Treasurer learns on Aug 19, 2002 this his/her MNC will receive $20m in June 2003 from sale of merchandise, and these funds will be invested for 3 months in the money market. Current LIBOR is 1.77% and expected LIBOR in June 03 according to futures trading is 2.36% (59 BP higher). Treasurer decides to lock in at that rate to eliminate interest rate risk (int rates falling back down below 2% in 03), takes a LONG position (BUYS Eurodollar forward @ 97.64 to lock in 2.36% rate). To hedge entire amount of $20m, he buys 20 Eurodollar contracts @ $1m.

This strategy will guarantee interest income of $20m x .0236 x .25 = $118,000. Interest rate risk without Eurodollar futures: For every BP below 2.36, the MNC would lose $500 in interest income ($20m x .0001 x .25 = $500). For example, if interest rates were only 2% in June 03, the MNC would receive $18,000 less ($20m x .02 x .25 = $100,000 vs. $118,000).

Assume at expiration, 3 month LIBOR is 2.10%, P = 97.90 (100 - 2.10). Now the $20m will only generate $20m x (2.1% / 4) = $105,000 of interest income. However, there will be a profit from the futures contract to make up the difference. Profit from futures = (97.90 - 97.64) x 100 bp x $25 ($100/4) = $650 profit per contract x 20 contracts = $13,000. $105,000 interest income + $13,000 futures profit = $118,000.

Main Point: a) The 2.36% interest rate has been guaranteed with the Eurodollar futures contract, which b) then guarantees the $118,000 interest income, regardless of what happens to interest rates. Interest rate can fall to 1% or rise to 3%, or change to any other rate, and the rate and income are guaranteed and locked. No risk.

Note: There are actually two parts to the outcome. 1) Company invests at whatever the current, or spot, Eurodollar interest rate prevails in June 03. 2) The company settles the Eurodollar futures contract in cash.

If market (spot) Eurodollar interest rates had risen above 2.36% in June 03, the company would have gotten more interest income than $118,000, but would have lost money on the futures contract, offsetting the additional interest income. No matter what happens to market int rates in June 03, the treasurer has locked in @ 2.36% almost one year ahead of time.

Example: Assume at expiration, 3 month LIBOR is 2.50%, P = 97.50 (100 - 2.50). Now the $20m will generate $20m x (2.5% / 4) = $125,000 of interest income. However, there will be a loss on the futures contract. Loss from futures = (97.50 - 97.64) x 100 bp x $25 ($100/4) = -$350 profit per contract x 20 contracts = -$7,000. $125,000 interest income - $7,000 futures loss = $118,000.

CURRENCY OPTIONS

Another derivative security, derives value from price movements of an underlying asset, without necessarily ever owning the asset. "Side Bet."

Option - contract that gives the owner the right, but not the obligation, to buy/sell a specific amount of an asset (or currency) at a specified price or ex-rate (strike price), on or before some date in the future (expiration). Gives you the right to decide later whether to buy/sell/exercise your option.

Mortgage - you have a prepayment option - the right, but not the obligation, to pay off the mortgage early (callable).

Right of first refusal - an option that gives you the right to buy an asset, movie, or TV show, before anyone else.

Convertible bond - you have the right, but are not obligated, to convert your bond into stock.

Call Option - an option to BUY an underlying asset 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 $1.50 (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, 2004. You will exercise the option if P > $30, and you will make money if the P > $31.50 ($30 + $1.50). If P ≤ $30, you will not exercise the option, it will expire worthless and you will lose the premium ($1.50). See diagram below:

Call Buyer

Profit

(+)$1.50

$30 $31.50

-$1.50

Loss Call Writer

(-)

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 - 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 2004 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.

Profit

(+) $2 Put Seller

$28 $30

-$2 Put Buyer

Loss

(-)

Two types of options: American (can be exercised any time at or before expiration) and European (can ONLY be exercised at expiration).

CURRENCY OPTIONS MARKETS

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 $50,000. 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.

CURRENCY FUTURES OPTIONS

CME offers (American) options on its currency futures contracts. The underlying asset is a currency futures contract, not the actual currency. "Side bet on a side bet." The cycle is the same for futures options as for futures - Mar, June, Sept and Dec., with options traded on the two earliest months.

Example: In Jan, option contracts would trade for Jan, Feb and March expiration on March futures contracts. Contracts are now trading for Oct, Nov and Dec expiration on December currency futures contracts.

Exercise of a currency futures option results in a LONG futures position for the Call Buyer and the Put Writer (seller) and SHORT futures position for the Call Writer and the Put Buyer. To cancel out the futures position before expiration, the trader can make an offsetting trade. If not, delivery or receipt of the currency will take place.

OPTION EXAMPLE 9.5

Consider the SF call options for Sept on p. 212, Premium = $.0030 or .30¢ per SF, with an Ex-P = $0.67/SF. The option contract will make money for a buyer if S > $.673 (.67 + .003), see Exhibit 9.8A on p. 214. You pay a premium of .30¢ per SF and have the right to buy SF for 67¢. Suppose at expiration, S = $.7025/SF, you will make money, ($.7025 - .673) x SF62,500 = $1843.75.

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 $.7025 on expiration, you can exercise your right to buy @$.67 and then sell at $.7025, for a gross profit of $2,031.25. Subtracting 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.

Your return on investment 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 currency value.

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.

PUT OPTION FOR CURRENCY

Look at the Sept put option for Euro, with a strike price of $1.04 (104 cents), and a premium of 2.47 cents, contract size of €62,500. You have paid for the right to sell Euros for 104 cents. Total Premium is $1,543.75 per contract, (€62,500 x $0.0247) and the break-even point is 101.53¢ (104 - 2.47), or $1.0153/€. If you buy the put, you will make money if spot rate for € < 101.53. Max loss is premium of -2.47¢ x 62,500 = $1,543.75. If you sell the put, you will make money if spot rate S > 101.53, the max gain is premium of $1,543.75.

If spot rate S = $1.0425 on expiration, the put owner would not exercise option and lose the premium of $1543.75, which would be the profit for the put writer. If S = 101 or $1.01, you would make gross profit of $1.04 - $1.01 = .03 x €62,500 = $1,875. Logic: You can buy 62,500 Euros at the spot rate of $1.01, and you have the right to sell at $1.04, for a $.03/€ profit x 62,500 = $1,875. However, you paid $1,543.75 for the right to sell Euros at 104, so your net gain/profit is $1,875 - $1,543.75 = $331.25. Or you can calculate profit: ($1.0153 - $1.01) x 62,500 = $331.25 (or 101.53 cents - 101 cents = .53 cents or $.0053 profit per Euro x €62,500 = $331.25 Total Profit.

HEDGING STRATEGIES USING FUTURES AND OPTIONS for CURRENCY RISK

For currency risk, you could use the following strategies.

1. If you are worried about £ (BP) falling ($ rising) in value, e.g. US Exporter receiving BP in 3 months, you could go the following:

a. Go short on a BP futures contract
b. Buy a put option on BP
c. Write a call option on BP
d. Buy a put option on BP futures
e. Write a call option on BP futures
f. Enter into a forward contract to sell BP forward

2. If you are worried about BP rising in value ($ falling), e.g., U.S. Importer paying in BP in 3 months, you could do the following:

a. Go long on a BP futures
b. Buy a call option on BP
c. Write a put option on BP
d. Buy a call option on BP futures contract
e. Write a put option on BP futures contract
f. Enter into a forward contract to buy BP forward