International Finance

http://www.nasdaqtrader.com/content/phlx/FXOptionsSpecsFS.pdf

http://www.nasdaq.com/markets/currency-options.aspx

14

15

15

16

http://www.ise.com/options/products-traded/

16

17

In addition to options that have their underlying as foreign currency, option traders may also trade options where the underlying is a currency future

17

18

*Electronic trading includes market makers

http://www.cmegroup.com/trading/fx/

18

19

19

Why currency futures options rather than currency (spot) options?

Most of the volume traded through currency options takes place in the over-the-counter (OTC) market (We’ll discuss this market below)

Whereas currency futures options, like currency futures, trade on exchanges and have superior liquidity

20

20

Optional: Why options on futures in general?

Futures are more liquid than the underlying in general: consider Treasury bonds vs. Treasury bond futures

Futures prices are known immediately: to get spot prices on Treasury bonds dealers would have to be contacted

Futures and futures options trade side-by-side in pits on the same exchange and pricing is therefore more efficient

Exercising a futures option does not lead to delivery of an underlying

Exercising leads to a futures position that can be easily and quickly closed out and cash settled

Consider the difference between exercising a CME futures option on 500 dry metric tons of iron ore vs. exercising a (spot) option on tons of iron ore itself!

Moreover, the exercise of a spot option would require substantial capital, whereas a future requires only margin

Futures options tend to entail lower transactions costs than spot options

21

21

Foreign Currency OTC Options

A significant majority of FX Options are traded OTC (“over the counter”)

In opposition to exchange traded options where only standardized periods and strikes can be traded there are no similar contract specification restrictions in the OTC market

So, most currency options are bought or sold by banks in a dealer network in the interbank or retail over-the-counter (OTC) markets—not listed on any centralized exchange

22

22

Characteristics of OTC FX Options

Typical OTC options use the European exercise convention as opposed to the American convention

They are tailor made and, not surprisingly, they have larger bid-ask spreads than exchange-traded options

OTC options settle 2 business days after notification of exercise. Either the writer and the holder exchange currencies or the writer cash settles with the holder—probably more often cash settled

Most of the OTC options are written with the strike equal to the current spot price (that is, at the money) but most reasonable requests for strike price, maturity, etc. will be quoted by a bank

23

23

OTC options are typically written for large amounts—rarely for less than $1M or the equivalent in an other currency

For OTC options, a broader range of currencies are available as compared to exchange-traded currency options

Still, OTC options most often exchange US dollars against British pounds, Swiss francs, Japanese yen, Canadian dollars and the euro—the standard world currencies

Option premiums are quoted either in:

Percent of the base (underlying) currency or

In quote currency per unit of base currency—0.01 or 0.0001 units of quote currency per unit of base (underlying) currency

24

24

Example: Option Premium Quotation

GBP/USD Put

Contract volume: GBP 5M

Premium 2.0 %

Buyer pays a premium of GBP 5M x 2.0 % = GBP 100,000

GBP/USD Put

Contract volume: GBP 5M

Premium 3 Ct

Buyer pays a premium of GBP 5M x = USD 150,000

25

25

Dodd-Frank

The Dodd-Frank Wall Street Reform and Consumer Protection Act impacts FX OTC options

Treasury issued a final rule that exempts both FX swaps and FX forwards from the definition of "swaps“ but clearly states the Treasury Exemption does not extend to any other type of FX derivative transaction

The Commodity and Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) jointly issued rules further defining the term "swap" under Dodd-Frank.

The final rules thus confirmed that the following FX derivatives would be treated as non-exempt FX swaps:

Foreign currency options

Non-deliverable forward contracts involving foreign exchange

Currency swaps and Cross-currency swaps

26

Consequently, these instruments will need to be cleared and exchange traded; however, to date, the CFTC has not issued any proposals to require clearing and electronic trading of any FX derivative

Further, a swap counterparty may elect not to clear a swap under the End-user Exception if the counterparty:

(i) Is not a “financial entity” (e.g., swap dealer, major swap participant, investment fund, bank, or pension plan);

(ii) Is using the swap to “hedge or mitigate commercial risk,” as further defined; and

(iii) Provides certain information along with the swap to a swap data repository or the Commission

27

FX Options Payoffs & Profits

28

28

Payoffs and Profits

Suppose we have the following two European options:

Call option on GBP

Strike price=$1.70 per £

Premium=$0.01 per £

Put option on GBP

Strike price=$1.70 per £

Premium=$0.01 per £

What are the option payoffs (monies at maturity) and profits (payoffs net of the premiums) for the holder and writer of each option?

29

29

30

Buyer/Holder of a Call Option

Payoff/Profit

($ per £)

+ 0.01

0

- 0.01

1.68

1.69

1.71

1.72

1.70

Payoff

“Out of the money”

“In the money”

“At the money”

Spot price

($ per £)

Call PayoffHolder = (Spot − Strike)+

Call ProfitHolder = (Spot − Strike)+ − Premium

Profit

Break-even price

30

Payoff and Profit for the Holder of a Call Option

Taking into account contract size:

31

Discussion: What does the payoff to a long position in a Future look like??

31

A Long Position on £ Futures at Maturity

32

Payoff

($ per £)

+ 0.01

0

- 0.01

1.68

1.69

1.71

1.72

1.70

Payoff

Spot price

($ per £)

Payoff Futures at Maturity = (ST − F0)

F0 = Strike = $1.70/£

Seller/Writer of a Call Option

33

Payoff/Profit

($ per £)

+ 0.01

0

- 0.01

1.68

1.69

1.71

1.72

1.70

Spot price

($ per £)

Payoff

Call PayoffWriter = − (Spot − Strike)+

Call ProfitWriter = Premium − (Spot − Strike)+

Break-even price

Unlimited loss to writer!!!

Profit

33

Payoff and Profit for the Writer of a Call Option

Taking into account contract size:

Options are zero-sum games—the holder’s gain is the writer’s loss

34

34

35

Buyer/Holder of a Put Option

+ 0.01

0

- 0.01

1.68

1.69

1.71

1.72

1.70

Payoff

“Out of the money”

“In the money”

“At the money”

Spot price

($ per £)

Put PayoffHolder = (Strike − Spot)+

Put ProfitHolder = (Strike − Spot)+ − Premium

Profit

Break-even price

Payoff/Profit

($ per £)

35

Payoff and Profit for the Holder of a Put Option

Taking into account contract size:

36

Discussion: What does the payoff to a short position in a Future look like??

36

A Short Position on £ Futures at Maturity

37

Payoff

($ per £)

+ 0.01

0

- 0.01

1.68

1.69

1.71

1.72

1.70

Payoff

Spot price

($ per £)

Payoff Futures at Maturity = (F0 − ST)

F0 = Strike = $1.70/£

38

Seller/Writer of a Put Option

Loss

0

Payoff

Profit

Break-even price

Put PayoffWriter = − (Strike − Spot)+

Put ProfitWriter = Premium − (Strike − Spot)+

+ 0.01

- 0.01

1.68

1.69

1.71

1.72

1.70

Spot price

($ per £)

Payoff/Profit

($ per £)

38

Payoff and Profit for the Writer of a Put Option

Taking into account contract size, these formulas become:

Again, options are zero-sum games—the holder’s gain is the writer’s loss

39

39

Using FX Options

40

40

Using Foreign Currency Options

41

http://www.nasdaq.com/markets/currency-options.aspx?currency=^XDB

41

Hedging with Currency Options

Example from the Futures Topic: Carnival Cruise Line offers Alaskan Inner Passage Cruises in the summer. Suppose Carnival contracts the use of a pier with the Vancouver Port Authority in Canadian dollars at a rate of CAD1M for the summer due in June. Passengers pay Carnival in USD and the dollar is Carnival’s currency of operation

Currently, the expected June spot exchange rate is 0.80 USD per CAD implying an obligation of 1M x 0.80 = USD 800,000

What happens if the USD depreciates relative to CAD such that next summer the exchange rate becomes 0.90 USD per CAD? The cost rises to 1M x 0.90 = USD 900,000

Relative to the line’s expected revenues in USD, its costs for docking have risen and its profits have fallen!

42

How would Carnival’s cash flows compare between using a PHLX FX option vs. a long on the CME CAD future?

42

Carnival recognizes that Nasdaq OMX PHLX trades options on the CAD and reconsiders its hedge

The PHLX contract specifications are:

Contract Size: 10,000 CAD

Settlement: Cash settlement

Which option should Carnival use?

Which maturity should Carnival select?

How many contracts are required to hedge?

43

Call

Put

March

June

September

December

100

43

Assume the strike price on the option selected equals the initial futures price:

And assume the premium is:

44

Strike = F0 = 0.80USD per CAD

Premium = 0.01USD per CAD

44

Looking at option payoffs alone:

45

Cash settled: (0.70USD per CAD - 0.80USD per CAD)+x CAD10,000 x 100

Cash settled: (0.90USD per CAD - 0.80USD per CAD)+x CAD10,000 x 100

45

Now, let’s look at the Payoff difference between the option and futures hedge:

46

(0.70USD per CAD - 0.80USD per CAD) x CAD100,000 x 10

(0.70USD per CAD - 0.80USD per CAD)+x CAD10,000 x 100

46

Now, considering the option premium…and compare to the futures hedge:

47

(USD 0.01 per CAD) x CAD10,000 x 100

47

48

Discussion:

What’s the comparative benefit of hedging with options vs. futures?

What’s the cost?

48

Hedging: Futures vs. Options

The foreign currency future contract is an obligation—even if prices change in an unanticipated way, the parties are obligated to fulfill the terms of the contract

The buyer of a foreign currency option contract, on the other hand, has a right, but not an obligation, to purchase/sell a currency at some point in the future at a price agreed upon today—

However, if prices change in an unexpected manner, the buyer of the option contract is under no obligation to exercise the option

49

49

Consequently, Futures (and forward contracts) are more suitable for hedging a known amount of foreign currency flow

Option contracts are better suited to situations where a firm is hedging foreign exchange exposure when the foreign currency flow is uncertain

If it turns out that the hedge is not needed—the foreign currency flow does not occur—the futures hedge actually becomes a source of risk!

In addition, option contracts might be better suited to situations where large price changes are anticipated, but the direction of the change is highly uncertain

50

50

Speculating with Currency Options

Example: Frank believes that the New Zealand dollar (NZD) will rise—more than other market participants—in value against the US dollar and looks at quotes for the NZD European-style option contract that trades on PHLX.

Frank believes that the spot rate by next March will significantly exceed 0.8500 USD per NZD

He decides to buy one call option (why not a put?) contract with

A strike price of 0.8500 USD per NZD

March maturity

Contract size of 10,000 NZD

Which sells on the PHLX for a premium of USD 0.0025 per NZD

51

http://www.nasdaq.com/aspxcontent/optionsWC.aspx?symbol=^XDZ&qm_page=98983&qm_symbol=^XDZ

51

At a spot rate next March above the strike of 0.8500 USD per NZD, Frank might exercise the option, paying only the strike price

At a spot rate below this strike price, Frank would not exercise his option (NZDs are cheaper on the spot market)

Frank’s maximum loss would be limited to the cost of the option contract: 0.0025 USD per NZD

52

52

Frank’s break-even spot price at contract maturity can be calculated by summing the premium with the strike price:

That is, at the break-even, the net payoff from exercising the option exactly matches the option premium

53

Break-even Spot Price = 0.8500 + 0.0025 = 0.8525 USD per NZD

Suppose Frank’s view turns out to be correct!

In the spot market at option maturity in March, the NZD trades at 0.8600 USD per NZD

Frank profits:

54

Exercise at expiration is generally automatic and handled by the Options Clearing Corporation, but most option traders close out their positions with offsetting contracts prior to expiration —unless expiration happens to be advantageous to the trader

54

FX Options Pricing

55

55

Intrinsic Value and Time Value

The intrinsic value is the financial gain if the option is exercised immediately (assuming it could be exercised)

This value will be zero when the option is at- or out-of-the-money

When the spot rate rises above (below) the strike price, the call (put) option will be in-the-money and this value will be positive

At maturity date, the option will have a value equal to its intrinsic value

But, time value—in addition to the intrinsic value of the option—exists prior to expiration because the price of the underlying (base) currency has the potential to move further into the money before maturity

56

56

Time Value

Example: A two-state, conceptual example with a 50% chance that the underlying will fall in value and a 50% chance that the underlying will rise in value (by the same amount):

Often, exercising an American FX option early would not be optimal—that would kill the time value! In this case, a European and American option will have the same value

57

Current Spot Rate

Low Terminal Spot Rate

High Terminal Spot Rate

Time Value

Low Payoff

High Payoff

Expected Payoff

57

Volatility

In addition to time to maturity, option values increase with the volatility of the price of the underlying (base) currency

Because the price of the underlying currency has the potential to move further into the money before maturity, the greater the volatility of the underlying is, the greater is the value of the option (typically)

58

58

Effect of Volatility

Example: A two-state, conceptual example with a 50% chance that the underlying will fall in value and a 50% chance that the underlying will rise in value (by an equal amount):

59

Current Spot Rate

Low Terminal Spot Rate: High Volatility

High Terminal Spot Rate: High Volatility

E[Payoff]: High Volatility

E[Payoff]: Low Volatility

Low Terminal Spot Rate: Low Volatility

High Terminal Spot Rate: Low Volatility

Effect of Volatility

59

Option Pricing with Black-Scholes

Pricing of an option, say, on pounds sterling, combines six elements

Spot rate

Strike or Exercise Exchange Rate

Time to maturity in years

Volatility, the standard deviation of daily spot rate movement

US dollar interest rate per annum

British pound interest rate per annum

60

60

Not Required: The “Greeks”

61

Option values are sensitive to changes in input values (in addition to time to maturity and volatility). These sensitivities are called “The Greeks”