Foreign Currency Derivatives: Futures and Options - Summary Points & Case Study Questions

Currency options as a speculative device

1. Foreign currency futures contracts are standardized forward contracts. Unlike forward contracts, however, trading occurs on the floor of an organized exchange rather than between banks and customers.

2. Futures also require collateral and are normally settled through the purchase of an off setting position. Corporate financial managers typically prefer foreign currency forwards over futures out of simplicity of use and position maintenance. Financial speculators typically prefer foreign currency futures over forwards because of the liquidity of the futures markets.

3. Foreign currency options are financial contracts that give the holder the right, but not the obligation, to buy (in the case of calls) or sell (in the case of puts) a specified amount of foreign exchange at a predetermined price on or before a specified maturity date.

4. The use of a currency option as a speculative device for the buyer of an option arises from the fact that an option gains in value as the underlying currency rises (for calls) or falls (for puts). The amount of loss to the buyer of the option when the underlying currency moves opposite to the desired direction is limited to the option premium.

5. The use of a currency option as a speculative device for the writer (seller) of an option arises from the option premium. If the option either a put or call expires out-of-the money (valueless), the writer of the option has earned, and retains, the entire premium.

6. Speculation is an attempt to profit by trading on expectations about prices in the future.

In the foreign exchange market, one speculates by taking a position in a foreign currency and then closing that position afterward; a profit results only if the rate moves in the direction that the speculator expected.

7. Currency option valuation, the determination of the option’s premium, is a complex combination of the current spot rate, the specific strike rate, the forward rate (which itself is dependent on the current spot rate and interest differentials), currency volatility, and time to maturity.

8. The total value of an option is the sum of its intrinsic value and time value. Intrinsic value depends on the relationship between the option’s strike price and the current spot rate at any single point in time, whereas time value estimates how intrinsic value may change—for the better—prior to maturity.

Korean banks argued that they had no such specific duty, and regardless, they had explained the risks sufficiently. The banks argued that this was not a case of an unsophisticated buyer not understanding a complex product; both buyer and seller were sufficiently sophisticated to understand the intricate workings and risks of these structures.

The banks had, in fact, explained in significant detail how the exporters could close out their positions and then limit the losses, but the exporters had chosen not to do so. In the end the Korean courts found in favor of the exporters in some cases, in favor of the banks in others. One principle that the courts followed was that the exporters found themselves in “changed circumstances” in which the change in the spot exchange rate was unforeseeable, and the losses resulting too great. But some firms lost heavily, for example, GM Daewoo lost $1.11 billion. Some Korean banks suffered significant losses as well and may have, in fact, helped transmit the financial crisis of 2008 from the United States and the European Union to many of the world’s emerging markets.

Foreign currency futures and options compared

1. What were the expectations—and the fears—of the South Korean exporting firms that purchased the KiKos?

2. What is the responsibility of a bank that is offering and promoting these derivative products to its customers? Does it have some duty to protect their interests? Who do you think was at fault in this case?

3. If you were a consultant advising firms on their use of foreign currency derivative products, what lessons would you draw from this case, and how would you communicate that to your clients?

1. Foreign Currency Futures. What is a foreign currency future?

2. Futures Terminology. Explain the meaning and probable significance for international business of the following contract specifications:

a. notional principal
b. margin

c. marked-to-market

3. Long and a Short. How can foreign currency futures be used to speculate on the exchange rate movements, and what role do long and short positions play in that speculation?

4. Futures and Forwards. How do foreign currency futures and foreign currency forwards compare?

5. Puts and Calls. Define a put and call on the British pound sterling. Options Versus Futures. Explain the difference between foreign currency options and futures, and when either might be most appropriately used. Call Option Contract. Suppose that exchange-traded American call options on pounds sterling with a strike price of 1.460 and a maturity of next March are now quoted at 3.67. What does this mean to a potential buyer?

6. Premiums, Prices, and Costs. What is the difference between the price of an option, the value of an option, the premium on an option, and the cost of a foreign currency option?

7. Three Prices. What are the three different prices or “rates” integral to every foreign currency option contract? Writing Options. Why would anyone write an option, knowing that the gain from receiving the option premium is fixed but the loss, if the underlying price goes in
the wrong direction, can be extremely large?

 

8. Decision Prices. Once an option has been purchased, only two prices or rates are part of the holder’s decision-making process. Which two and why?

9. Option Cash Flows and Time. The cash flows associated with a call option on euros by a U.S. dollar-based investor occur at different points in time. What are  they, and how much does the time element matter?

10. Option Valuation. The value of an option is stated to be the sum of its intrinsic value and its time value. Explain what is meant by these terms. Time Value Deterioration. An option’s value declines over time, but it does not do so evenly. Explain what that means for option valuation.

11. Option Values and Money. Options are often described as in-the-money, at-the money, or out-of-the-money. What does that mean, and how is it determined?

12. Option Pricing and the Forward Rate. What is the relationship or link between the forward rate and the foreign currency option premium?
Option Deltas. What is an option delta? How does it change when the option is in-the-money, at-the-money, or out-of-the-money? Historic Versus Implied Volatility. What is the difference between a historic volatility and an implied volatility?