Lesson VI: Currency Derivatives, an Overview IV.pdfCurrency Futures Currency Options To Sum Up Synthetic Fwds Terminology To Put It into Practice Lesson VI: Currency Derivatives, an

InternationalFinancial and

Foreign ExchangeMarkets

Roadmap

Outright FwdContracts

Currency Futures

Currency Options

To Sum Up

Synthetic Fwds

Terminology

To Put It intoPractice

Lesson VI: Currency Derivatives, anOverview

Monday 27th April, 2020



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Currency Futures

Currency Options

To Sum Up

Synthetic Fwds

Terminology


Table of Contents

Roadmap

Outright Fwd Contracts

Currency Futures

Currency Options

To Sum Up

Synthetic Fwds

Terminology

To Put It into Practice



Roadmap


Currency Futures

Currency Options

To Sum Up

Synthetic Fwds

Terminology


Roadmap



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Currency Futures

Currency Options

To Sum Up

Synthetic Fwds

Terminology


Outright Fwd Contracts: Definition and Payoff

Outright Fwd Contracts: Tailor-made OTC agreement toexchange currencies at a pre-determined price on a futuredate.In intuitive terms, this allows to set now the price at whicha given currency will be bought or sold on a given futuredate⇒ at maturity, the payoff of a fwd depends on therealized spot rate at that time.



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Currency Options

To Sum Up

Synthetic Fwds

Terminology


Payoff Profile of a Long Fwd to Buy EUR vs USD



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Terminology


Benefits and Risks of Fwds

I High FlexibilityI Not only major currenciesI Customizable maturities and notional amountsI Deliverables vs Non deliverables

I No CCTP: Higher settlement risk

I Reduced mkt liquidity



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Futures: Definition and Comparison with Fwds

Currency Futures: standardized contracts drawn either tobuy or to sell a fixed amount of foreign currency on apre-determined date sometime in the futureUnlike fwds, however, currency futures:

I trade for standardized amounts (depending on thecurrency)

I trade for a limited number of maturity dates(typically, March, June, September and December)

I settle gains or losses on a daily basis⇒ Mark toMarket



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Focus on the MtM

Futures are CCTP-based ⇒ the Clearing House requiresboth parties of a futures transaction to post margins in amargin account held at a brokerage house

I The amount of margins to be posted is typically a % ofthe notional amount

I The margins’ balance is updated daily, depending onthe market value of the contract (computed at the dailysettlement price)

I Whenever the balance falls below a pre-specifiedthreshold (maintenance level) after the daily MTM, theinvolved party will receive a margin call to postadditional money in the margin account



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MtM: Digging Deeper into Daily Mkt Practice

Suppose that, on June 1st, you bgt a GBP future contractat 1.55 USD

GBP to purchase GBP 63,000 in three months.Assume further that

I Required Initial Margin = USD 6,000

I Maintenance Margin = USD 5,000

June 1st June 2nd June 3rdSettlement Px 1.55 1.57 1.53USD Fut.Val 97,650 98,910 96,390

USD Daily PL 0 1,260 -2,520Mrg.Balance 6,000 7,260 4,740

Mrg.Call No No 260



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In more practical terms...

A futures contract is equivalent to entering a forwardcontract each day and settling each forward contractbefore opening another one.If you conversely buy (sell) a fwd contract all the gains(losses) will be eventually realized (incurred) at maturity,depending on the future realized spot rate at that time.



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MtM and Futures vs Fwds: a Wrap Up

I FuturesI CCTP (Clearing House) bearing the settlement risk ⇒

Margins are requiredI The amount in the margin account not only depends on

the entire path of the futures price from the initialpurchase, but also on the interest rates earned in theaccount or forgone on cash contributions to the account⇒ Marking-to-market risk

I FwdsI No CCTP: the settlement risk is faced by the two

parties involved ⇒ No margins are requiredI Gains or losses on the forward positions will be

eventually realized at the maturity of the contracts ⇒No marking-to-market risk



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Synthetic Fwds

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Payoff Profile of a Long Future to Buy EUR vsUSD



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Currency Futures

Currency Options

To Sum Up

Synthetic Fwds

Terminology


Benefits and Risks of Futures

I Low FlexibilityI Mainly major currenciesI Fixed, standardized maturities and notional amountsI Well-defined trading time and trading rules

I CCTP: No settlement risk

I High mkt liquidity



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Terminology


Options: Definition and Overview

Options are derivative contracts that give the buyer theopportunity (not the obligation) to buy or to sell theunderlying asset at a given price sometime in the future(either at or up to maturity).Watch out:

I Call: right to buy

I Put: right to sell

I European Option: exercise at maturity

I American Option: exercise up to maturity



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Moneyness and Intrinsic Value

Assume:

I S: market price of the underlying

I X: strike price

I Premium=0

In the Money At the Money Out the MoneyC S>X S=X S<XP S<X S=X S>X

Intrinsic Value: extent to which an option is in the money



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The Drivers of an Option’s Mkt Value I

I Intrinsic Value: the more the option is in the money,the higher is the option premium

I Volatility of the underlying exchange rate: the morevolatile is the underlying, the greater the chance thatthe option will be exercised (ceteris paribus)

I American vs European option type: Americanoptions are more “flexible” and consequently morevaluable than European options

I Interest rates: the higher the interest rates, the lowerthe present value of the exercise price. This shouldincrease (reduce) the mkt value of a call (put)



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The Drivers of an Option’s Mkt Value II

I Forward premium/ discount: (ceteris paribus) thegreater is the fwd discount (i.e. the expected decline inthe FX value of a currency), the higher (lower) is thevalue of a put (call) option. The reverse holds for fwdpremia

I Length of the period to expiry: (ceteris paribus) thelonger the maturity, the greater the chance that theoption will move into money



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Payoff Profile of a Long Call



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Payoff Profile of a Long Put



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Currency Options

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Synthetic Fwds

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Benefits and Risks of Options

I Low FlexibilityI Mainly major currenciesI Fixed, standardized maturities and notional amountsI Well-defined trading time and trading rules

I CCTP: No settlement risk

I High mkt liquidity

I Optionality



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To Sum Up

Fwds Futures OptionsTrading OTC Reg. Mkts Reg. Mkts

Discretion None None Buyer’sMaturity Any Date Std Dates Std DatesNotional Any Std StdMargins None CH-Defined CH-DefinedCCTP No Yes Yes

Major Users Hedgers Speculators Both



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Flexibility vs Standardization

What is the advantage of standardization over flexibility?

The more homogeneous (and the fewer) are the contracts,the higher is the market depth



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Building a Synthetic Fwd: Step 1

Suppose that, at time t0, you decide to:

I Buy a Call on the USDEUR exchange rate (premium: C)

I Sell a Put on the USDEUR exchange rate (premium: P)

Suppose further that the 2 options have:

I The same maturity: tTI The same strike price: X USD

EUR



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Step 1: Profit and Loss at Maturity

Deal CFt0 CFtT CFtTif S < X if S > X

Long Call -C 0 SUSDEUR

-XUSDEUR

Short Put P SUSDEUR

-XUSDEUR

0

Total P-C SUSDEUR

-XUSDEUR

SUSDEUR

-XUSDEUR

Under both scenarios, the total CF at maturity will thusbe SUSD

EUR-XUSD

EUR.



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In Simpler Terms...

Notice that this is equivalent to the payoff of a fwdcontract drawn to purchase EUR with USD at maturity. Inalternative terms, at maturity there will be a USD cashoutflow together with a corresponding EUR inflow.



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Building a Synthetic Fwd: Step 2

SUSDEUR

-XUSDEUR

is practically equivalent to:

I A cash outflow: -XUSDEUR

I Combined with a cash inflow: SUSDEUR

Let’s put it all together

I Cash outflow at maturity ⇒ USD-denominated ⇒conceivable as the repayment of aUSD-denominated loan (originally stipulated at t0)

I Cash inflow at maturity ⇒ EUR-denominated ⇒conceivable as the proceeds of a EUR-denominatedinvestment (originally stipulated at t0)



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Step 2: Profit and Loss at Maturity

Deal CFt0 CFtT CFtTif S < X if S > X

LoanXUSD

EUR

(1+rUSD)T-XUSD

EUR-XUSD

EUR

Inv −SUSDEUR

(1+rEUR)TSUSD

EURSUSD

EUR

TotXUSD

EUR

(1+rUSD)T−

SUSDEUR

(1+rEUR)TSUSD

EUR-XUSD

EURSUSD

EUR-XUSD

EUR



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The Put-Call-Fwd Parity

Given that

P − C = SUSDEUR

-XUSDEUR

and

XUSDEUR

(1+rUSD)T−

SUSDEUR

(1+rEUR)T= SUSD

EUR-XUSD

EUR

It must be that

P − C =XUSD

EUR

(1+rUSD)T−

SUSDEUR

(1+rEUR)T

Put-Call-Fwd Parity



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Currency Fwds, Futures and Options

I Currency Fwds: tailor-made agreement to exchangecurrencies at a pre-determined price on a future date

I Currency Futures: standardized contracts drawneither to buy or to sell a fixed amount of foreigncurrency on a pre-determined date sometime in thefuture

I Currency Options: derivative contracts that give thebuyer the opportunity to buy or to sell the underlyingasset at a given price sometime in the future



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Over The Counter

OTC market: Widespread aggregation of dealers whomake markets in many different securities. Unlike anexchange on which trading takes place at one physicallocation, OTC trading occurs through telephone or computernegotiations between buyers and sellers.



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Market Maker

Market Maker: liquidity providing intermediary that quotesboth buying and selling prices for a given financialinstrument on a continuous basis.



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To Put It into Practice I

6.1: A put option on Australian dollars with a strike price ofUSD 0.80 is purchased by a speculator for a premium ofUSD 0.02. If the Australian dollars spot rate is USD 0.74 onthe expiration date, should the speculator exercise the optionon this date or let the option expire?Draw the buyer’s and the seller’s payoff charts.



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To Put It into Practice II6.2:A call option on Canadian dollars with a strike price ofUSD 0.60 is purchased by a speculator for a premium ofUSD 0.06 per unit. Assume each option calls for the deliveryof 50,000 CAD.

I If the Canadian dollar’s spot rate is USD 0.65 at thetime the option is exercised, what is the net profit tothe speculator?

I What would the spot rate need to be at the time theoption is exercised for the speculator to break even?

I What is the net profit to the seller of this option?I Draw the buyer’s and the seller’s payoff charts.



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To Put It into Practice III

6.3: Given the information below (investment period 1 yr),find the put premium

CallC1C2

Premium 0.01 C1

CallC1C2

Strike 0.63 C1

PutC1C2

Strike 0.63 C1

rC1 0.055rC2 0.075

S0C1C2

0.625

Documents

Lesson VI: Currency Derivatives, an Overview IV.pdfCurrency Futures Currency Options To Sum Up Synthetic Fwds Terminology To Put It into Practice Lesson VI: Currency Derivatives, an