currency options and futures - Chapter 7 Currency...

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Chapter 7Currency DerivativesCurrency FuturesCurrency OptionsOther Derivatives
A futures contract is likea forward contract:It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today.A futures contract is different froma forward contract:Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.Futures Contracts: Preliminaries
Standardizing Features:Contract SizeDelivery MonthDaily resettlementInitial performance bond/margin (about 2 percent of contract value, cash or T-bills held in a street name at your brokerage).Futures Contracts: Preliminaries
Consider a long position in the CME Euro/U.S. Dollar contract.It is written on €125,000 and quoted in $ per €.The strike price is $1.30 the maturity is 3 months.At initiation of the contract, the long posts an initial performance bond (margin) of $6,500.The maintenance performance bond is $4,000.Daily Resettlement: An Example
Recall that an investor with a long position gains from increases in the price of the underlying asset.Our investor has agreed to BUY €125,000 at $1.30 per euro in three months time.With a forwardcontract, at the end of three months, if the euro was worth $1.24, he would lose $7,500 = ($1.24 – $1.30) × 125,000.If instead at maturity the euro was worth $1.35, the counterparty to his forward contract would pay him $6,250 = ($1.35 – $1.30) × 125,000.Daily Resettlement: An Example
With futures, we have daily resettlement of gains an losses rather than one big settlement at maturity.Every trading day:if the price goes down, the long pays the shortif the price goes up, the short pays the longAfter the daily resettlement, each party has a new contract at the new price with one-day-shorter maturity.Daily Resettlement: An Example
Each day’s losses are subtracted from the investor’s account.Each day’s gains are added to the account.In this example, at initiation the long posts an initial performance bond of $6,500.The maintenance level is $4,000.If this investor loses more than $2,500 he has a decision to make: he can maintain his long position only by adding more funds—if he fails to do so, his position will be closed out with an offsetting short position.Performance Bond Money
Over the first 3 days, the euro strengthens then depreciates in dollar terms:Daily Resettlement: An Example$1,250–$1,250$1.31$1.30$1.27–$3,750Gain/LossSettle$7,750$6,500$2,750Account Balance= $6,500 + $1,250On third day suppose our investor keeps his long position open by posting an additional $3,750.+ $3,750 = $6,500
Over the next 2 days, the long keeps losing money and closes out his position at the end of day five.Daily Resettlement: An Example$1,250–$1,250$1.31$1.30$1.27$1.26$1.24–$3,750–$1,250–$2,500Gain/LossSettle$7,750$6,500$2,750 + $3,750 = $6,500 $5,250$2,750Account Balance= $6,500 – $1,250
At the end of his adventures, our investor has three ways of computing his gains and losses:Sum of daily gains and losses– $7,500 = $1,250 $1,250 $3,750 $1,250 $2,500

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