Lecture 5: Currency Futures and Options Flashcards
What is a forward contract?
A commitment today by two parties to buy/sell something on a future date at a price agreed today.
What is a futures contract?
A commitment similar to a forward contract except it is designed by and traded on ann organised exchange.
Can be viewed as a standardized forward contract.
What is a options contract?
It is where one party purchases the right to buy/sell something in the future at a price agreed today.
It is expected that the buyer of the option will pay a premium for said right.
The option seller (writer) has a commitment to deliver if called to do so.
What/where are the major markets that currenncy forwards, currenncy futures and currency options are sold?
Currency Forwards: London but many other places to (circumstanncial)
Currency Futures: CME, NYSE, Euroext (LIFFE), CBoT
Currency Options: Philadelphia Stock Exchange, OTC London and many oher places
Explain the differences between forwards and futures contracts.
(Amount, currencies and delivery date; Cash flows; Delivery; Transaction costs; Deposits and margins; Credit risk)
Why are currecy futures used instead of currency forwards?
Primarily market access.
OTC wholesale forward market is restricted to big market players (e.g. banks, FX traders)
Define the following: call, put, exercise/strike price, exercise and expiry date, European optio, American option, payoff, Option price.
Call: option to buy underlying asset.
Put: option to sell underlying asset.
Exercise/Strike Price: the min/max price that the option will be exercised in the future.
Exercise: when the option buyer enforces the contract.
Expiry Date: date which the option ceases to exist.
European Option: an option that can only be exercised at maturity T.
American Option: an option that can be exercised on or before maturity.
Payoff: cashflow (if any) at maturity.
Option Price: Amount paid by the buyer to the seller to initiate the option (option premium)
Explain the intuition of currenncy options (i.e. how is payoff affected in the case of currency appreciation/depreciation)?
Call Option: Buy x quantity of FC (payoff = HC)
As HC appreciates against the FC payoff increases.
Put Option: Sell x quantity of FC (payoff = HC)
As HC depreciates against FC payoff inncreases.
Define Put-Call Parity I
A call buying FC (paying HC) is equivalennt to a put to sell HC (recieving FC).
Define Put-Call Parity II
If the exercise price of a European call is set equal to the forward rate, then the price of the correspooding put equals the price of the call.
Define forward rates for both direct and inndirect quotes.
What conditions need to be met to achieve arbitrage with Put-Call Parity II?
What steps need to be undertaken to achieve it?
If the price of a put and a call don’‘t equal then there is an arbitrage.
In order to complete the arbitrage you need to sell (buy) a FC foward and then sell/buy (buy/sell) both a call and put on the FC.
Define Put-Call Parity III
If a European put and a European Call on a FC have the same exercise price (X) and the same time to maturity T then,
How might arbitrage be achieved on the basis of Put-Call Parity III?
- Buy call on FC and deposit to earn HC interest
- Buy put on FC then use HC to buy at spot and deposit sum of FC into foreign account to earn rf
What is a range forward or collar?
it is like a forward contract but instead of a price at a particular level it is a range.
e.g. importer believes that the HC is likley to strenghten against FC but wants to be protected against the EX rate going above MAX (x).
How do you value a currency option (i.e. what is the formula)?
Define the inputs.
e0 = St EX rate in units of HC per FC
X = exercise price in units HC per FC
T = Maturity (years)
rf = foreign interest rate pa for term T
rh = home interest rate pa for term T
σ = volatility for EX rate
