International-Financial-Management---Bekaert-2e---Solutions---Ch20.doc

International-Financial-Management---Bekaert-2e---Solutions---Ch20.doc

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13

Chapter20:

ForeignCurrencyFuturesandOptions

Chapter 20

ForeignCurrencyFuturesandOptions

QUESTIONS

1.Howdoesafuturescontractdifferfromaforwardcontract?

Answer:

Foreigncurrencyfuturescontracts,orfuturescontractsforshort,allowindividualsandfirmstobuyandsellspecificamountsofforeigncurrencyatanagreed-uponpricedeterminedonagivenfutureday.Althoughthissoundsverysimilartoforwardcontracts,thereareanumberofimportantdifferencesbetweenforwardcontractsandfuturescontracts.

Thefirstmajordifferencebetweenforeigncurrencyfuturescontractsandforwardcontractsisthatfuturescontractsaretradedonanexchange,whereasforwardcontractsaremadebybanksandtheirclients.Ordersforfuturescontractsmustbeplacedduringtheexchange’stradinghours,andpricingoccursinthe“pit”byfloortradersoronanelectronictradingplatformwheredemandismatchedtosupply.Incontrasttoforwardcontracts,wheredealersquotebidandaskpricesatwhichtheyarewillingeithertobuyorsellaforeigncurrency,foreachpartythatbuysafuturescontract,thereisapartythatsellsthecontractatthesameprice.Thepriceofafuturescontractwithspecifictermschangescontinuously,asordersarematchedonthefloororbycomputer.

Asecondmajordifferenceisthatfuturesexchangesstandardizetheamountsofcurrenciesthatonecontractrepresents.Thus,futurescontractscannotbetailoredtoacorporation’sspecificneedsascanforwardcontracts.Butthestandardizedamountsarerelativelysmallcomparedtoatypicalforwardcontract,andiflargerpositionsaredesired,onemerelypurchasesmorecontracts.Standardizationwithsmallcontractsizesmakesthecontractseasytotrade,whichcontributestomarketliquidity.

Athirdmajordifferenceinvolvesmaturitydates.Intheforwardmarket,aclientcanrequestanyfuturematuritydate,andactivedailytradingoccursincontractswithmaturitiesof30,60,90,180,or360days.Thestandardizationofcontractsbythefuturesexchangesmeansthatonlyafewmaturitydatesaretraded.Forexample,IMMcontractsmatureonthethirdWednesdayofMarch,June,September,andDecember.Thesedatesarefixed,andhencethetimetomaturityshrinksastradingmovesfrom1daytothenext,untiltradingbeginsinanewmaturity.Typically,onlythreeorfourcontractsareactivelytradedatanygiventimebecauselonger-termcontractsloseliquidity.

Thefinalmajordifferencebetweenforwardcontractsandfuturescontractsconcernscreditrisk.Thisissueisperhapsthechiefreasonfortheexistenceoffuturesmarkets.Intheforwardmarket,thetwopartiestoaforwardcontractmustdirectlyassessthecreditriskoftheircounterparty.Banksarewillingtotradewithlargecorporations,hedgefunds,andinstitutionalinvestors,buttheytypicallydon’ttradeforwardcontractswithindividualinvestorsorsmallfirmswithbadcreditrisk.

Thefuturesmarketisverydifferent.Inthefuturesmarkets,aretailclientbuysafuturescontractfromafuturesbrokeragefirm,whichintheUnitedStatesistypicallyregisteredwiththeCommodityFuturesTradingCommission（CFTC）asafuturescommissionmerchant（FCM）.Legally,FCMsserveastheprincipalsforthetradesoftheirretailcustomers.Consequently,FCMsmustmeetminimumcapitalrequirementssetbytheexchangesandfiduciaryrequirementssetbytheCFTC.Inaddition,ifanFCMwantstotradeontheIMM,itmustbecomeaclearingmemberoftheCME.Inyearspast,clearingmembershipsusedtobetradable,andthepricesatwhichtheytradedwereindicationsofhowprofitablefuturestradingontheexchangewasexpectedtobe.In2000,theCMEbecameafor-profitstockcorporation,anditssharesnowtradeontheNYSE.Toobtaintradingrights,anFCMmustbuyacertainamountofB-sharesofCMEstockandmeetallCMEmembershiprequirements.

Whenatradetakesplaceontheexchange,theclearinghouseoftheexchange,whichisanagencyoraseparatecorporationofafuturesexchange,actsasabuyertoeveryclearingmembersellerandasellertoeveryclearingmemberbuyer.Theclearinghouseimposesmarginrequirementsandconductsthedailysettlementprocessknownasmarkingtomarketthatmitigatescreditconcerns.Thesemarginrequirementsarethenpassedontotheindividualcustomersbythefuturesbrokers.

2.Whateffectsdoes“markingtomarket”haveonfuturescontracts?

Answer:

Theprocessofmarkingtomarketimpliesthatfuturescontractshavedailycashflowsassociatedwiththem.Onecanbeeitherlong（havingboughtthecontract）orshort（havingsoldthecontract）inthefuturesmarketataparticularprice.Sincebothsidesaretreatedsymmetrically,let’sassumeyouarelong.Youmustpostfundsinamarginaccount,andifonsubsequentdays,thefuturespricemovesinyourfavor,thatis,theforeigncurrencyfuturespricesrisesastheforeigncurrencystrengthens;fundsareplacedintoyourmarginaccountandaretakenoutofthemarginaccountsofthosewhosoldtheforeigncurrencyfuturescontract.Thisprocesscontinueseverydayuntilthematuritydateofthecontract.

3.Whatarethedifferencesbetweenforeigncurrencyoptioncontractsandforwardcontractsforforeigncurrency?

Answer:

Theprimarydifferencebetweenaforeigncurrencyoptioncontractandaforwardcontractisthattheoptioncontractgivesthepurchaseroftheoption,theright,butnottheobligationtotransact.Ifthestateoftheworldinthefutureisfavorabletothepurchasersoftheoption,theywilltransact.Ifthestateoftheworldisunfavorable,theoptionisworthless.Forwardcontractsarecompletelyuncontingentonthestateoftheworldinthefuture.

4.WhatareyoubuyingifyoupurchaseaU.S.dollarEuropeanputoptionagainsttheMexicanpesowithastrikepriceofMXN10.0/$andamaturityofJuly?

（AssumethatitisMayandthespotrateisMXN10.5/$.）

Answer:

AEuropeanputoptiongivesyoutherighttoselltheunderlyingassetatthestrikepriceonthematuritydateofthecontract.Thus,youarebuyingtherighttosellUSDforMXNatthepriceofMXN10.0/$onthematuritydateofthecontractinJuly.Thisoptioniscurrentlysaidtobe“outofthemoney”becausethestrikepriceislowerthanthecurrentexchangerate.

5.WhatareyoubuyingifyoupurchaseaSwissfrancAmericancalloptionagainsttheU.S.dollarwithastrikepriceofCHF1.30/$andamaturityofJanuary?

（AssumethatitisNovemberandthespotrateisCHF1.35/$.）

Answer:

Americanoptionscanbeexercisedanytimebetweenthepurchaseoftheoptionandthematuritydate.Thus,aSwissfrancAmericancalloptionagainsttheU.S.dollarwithastrikepriceofCHF1.30/$andamaturityofJanuarygivesthebuyertheright,butnottheobligation,topurchaseCHFwithUSDatapriceofCHF1.30/$betweenNovemberandthematuritydateinJanuary.Theoptioniscurrentlysaidtobe“outofthemoney”becausethestrikeprice（expressedindollarsperSwissfranc）ishigherthanthecurrentexchangerate[（1/1.30）>（1/1.35）]andyouarepurchasingCHF.

6.Whatistheintrinsicvalueofaforeigncurrencycalloption?

Whatistheintrinsicvalueofaforeigncurrencyputoption?

Answer:

Theimmediaterevenuefromexercisinganoptioniscalledtheoption’sintrinsicvalue.LetKbethestrikeprice,andletSbethecurrentspotrate,bothindomesticcurrencyperunitofforeigncurrency.Then,theintrinsicvalueperunitofforeigncurrencycanberepresentedas

Calloption:

max[S–K,0]

Putoption:

max[K–S,0]

wheremaxdenotestheoperationthattakesthemaximumofthetwonumbersbetweensquarebrackets.

7.WhatdoesitmeanforanAmericanoptiontobe“inthemoney”?

Answer:

IfanAmericanoptionis“inthemoney,”itsintrinsicvalueispositive.Foracalloption,thismeansthatthestrikepriceislessthanthecurrentmarketprice;whileforaputoption,thismeansthatthestrikepriceisgreaterthanthecurrentmarketprice.

8.WhydoAmericanoptionvaluestypicallyexceedtheirintrinsicvalues?

Answer:

Thetimevalueofanoptionisthecurrentpriceorvalueoftheoptionminusitsintrinsicvalue:

Timevalueofanoption=Optionprice–Intrinsicvalue

Optionshavetimevaluebecausethestochasticevolutionoftheunderlyingassetpriceprovidespossibilitiesofevenbetterpayoffsinthefuturecomparedtotheintrinsicvalue.Ifthiswerenotthecase,theowneroftheAmericanoptionwouldexerciseit.

9.Supposeyougolonginaforeigncurrencyfuturescontract.Underwhatcircumstancesisyourcumulativepayoffequaltothatofbuyingthecurrencyforward?

Answer:

Thepayoffsoffuturescontractsandforwardcontractsareonly“essentiallythesame”becauseaslightdifferenceinpayoffsarisesduetothefactthatinterestisearnedonfutureprofits,orinterestmustbepaidonfuturelosses,inthemarkingtomarketprocess.Technically,ifthepathofshort-terminterestratescouldbeforeseen—thatis,iftherewerenorandomchangesinfutureshort-terminterestrates—therewouldbeanarbitragepossibilityiftheforwardexchangerateweredifferentfromthefuturespricebecauseyouwouldknowhowyoucouldinvesttheprofitsorborrowtofinanceyourlosses.However,futureinterestratesarenotknownwithcertainty,soforwardpricesandfuturespricescanbedifferent,intheory.Inpractice,though,thepricedifferentialsareminimal,andtheyappeartobewithinthetransactioncostsoftheforwardmarket.Therefore,wearguethatfuturespricesare“essentiallythesame”asforwardprices.

10.Whatisbasisrisk?

Answer:

Thebasisisthedifferencebetweenthepriceofthefuturescontractattimet,fora