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Understanding Futures and Options Basics

The document discusses various financial concepts including present value calculations, yield curves, interest rate parity, currency futures, and options. It explains how to manage currency risk through futures contracts and the implications of interest rate differentials on capital flows. Additionally, it compares forward contracts and swaps, highlighting their respective advantages and challenges.

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peterpark0903
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17 views3 pages

Understanding Futures and Options Basics

The document discusses various financial concepts including present value calculations, yield curves, interest rate parity, currency futures, and options. It explains how to manage currency risk through futures contracts and the implications of interest rate differentials on capital flows. Additionally, it compares forward contracts and swaps, highlighting their respective advantages and challenges.

Uploaded by

peterpark0903
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

1. Given that: PB = C/(1 + R) + C/(1 + R)2 + C/(1 + R)3 + C/(1 + R)4 + ...

multiply each side by (1 + R): PB (1 + R) = C + C/(1 + R) + C/(1 + R)2 + ...;

and subtract PB from each side: PB – PB (1 + R)= [C/(1 + R) + C/(1 + R)2 + ...] – [C + C/(1 + R)
+ C/(1 + R)2 +...] ;

Simplifying: –PB * R = –C.

Therefore, PB = C/R.

2. In this situation, annual yields decline as the term to maturity increases, which means that the
yield curve slopes downward. According to the expectations theory of the term structure of
interest rates, this situation arises because bond market traders anticipate that short-term interest
rates will fall sharply. Thus, an average of current and future short-term rates, which, when added
to any term premium applicable to a longer maturity, is lower than the current short-term rate.

3. Yes, the excess return on the German government bond equals 3.5% – (5% – 3%) = 1.5%.

4. Parity Conditions:
a. Using uncovered interest parity, R – R* = (S+1e – S)/S. Because the left-hand-side is negative,
at 5% – 6% = –1% , we would expect the right-hand side to be negative, indicating an
anticipated domestic currency appreciation.
b. Using relative PPP, %ΔPe – %ΔP*e = %ΔSe, where the “e” superscript denotes an expectation.
Because the left-hand side is negative, at 2% – 4% = –2%, indicating an anticipated domestic
currency appreciation.

5. The domestic real interest rate is 5 percent less 2 percent, or 3 percent. The foreign real interest
rate is 6 percent less 4 percent, or 2 percent. Real interest rates are not equal, so the real interest
parity condition does not hold. We would expect funds to flow into the domestic country and out
of the foreign country, which would drive the domestic real interest rate down and the foreign real
interest rate up.

6. In contrast to forward currency contracts, currency futures require delivery of standard quantities
of currencies. In addition, holders of currency futures experience profits or losses on the contracts
during the entire period before the contracts expire, whereas profits or losses occur only at the
expiration date of a forward currency contract.

7. A currency future already is a derivative, because its value varies with the exchange rate. The
value of a currency futures option, in turn, depends on the underlying value of a currency futures
contract, so its value is derived from the futures derivative . In this way, a currency futures option
is a “derivative of a derivative.”

8. a. The company has taken a long position in which it owes 500,000 Sfr, and it is concerned
about the future spot exchange value of the U.S. dollar-Swiss franc . It can therefore purchase
future contracts to offset some or all of its potential exchange rate losses.
b. The Sfr is purchased in 125,000 franc increments. Therefore, the firm would want to purchase
500,000/125,000 = 4 futures contracts. Given the initial margin on a franc contract, the total
initial margin the firm establishes is: 4($1,688) = $6,752.
The daily margin changes are as follows:
First: (0.6252 – 0.6251)(125,000)(4) = +$50. Therefore, its margin equals $6,802.
Second: (0.6127 – 0.6252)(125,000)(4) = –$6250. Therefore, the margin would fall to $552.
However, the maintenance margin is equal to $1,250, so the firm typically will have to
respond by moving funds to its margin account to bring it to at least the maintenance level.
Third: (0.6115 – 0.6127)(125,000)(4) = –$600. Again, the margin must remain at $1,250, so
the firm typically will have to respond by shifting funds into its account.
Fourth: (0.6806 – 0.6115)(125,000)(4) = –$1450. Again, this daily change would fall beneath
the maintenance margin, so the firm will have to move funds into its account.
c. As the dollar continues to appreciate relative to the Swiss franc, the value of the futures
contract falls. However, the cost of the 500,000 franc payment is becoming cheaper in terms
of the U.S. dollar.

9. a. The call option is currently out of the money.


b. (0.0188)(62,500) = $1,175
($1,175)(8 contracts) = $9,400

c. At S = $0.96/ € the option is not exercised and the firm is out $9,400.
At S = $1.02/ € the option is exercised. The firm earns $10,600.
At S = $0.9657/€, the firm does not exercise the option and is out $9,400.
d. Break even: $0.9988/€
e. See Diagram given in part (b).
10. The pros and cons of forward contracts and swaps lie within how each works. A forward contract
can be arranged between a purchaser and a seller, and is dependent upon each participant’s beliefs
of what will happen in the future. Sometimes it can be difficult to match counterparties to such
contracts. Swaps, on the other hand, directly match traders who require flows of currencies held
by one another trader. Swaps may also allow borrowers to receive better loan rates by issuing debt
in their home currency rather than in a foreign currency; thereby potentially avoiding a risk
premium. Considerations of the reason for the long position on a currency and which currency is
at issue will influence the decision of which derivative to use.

Common questions

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A currency futures option derives its value from the underlying futures contract, which itself is a derivative because its value fluctuates with exchange rates. Thus, the currency futures option is a 'derivative of a derivative,' implying its valuation is contingent on the complex interplay of two derivative markets .

Currency futures require delivery of standard quantities of currencies and involve daily settlement of profits and losses during the contract period. Conversely, forward contracts settle only at contract expiration, resulting in all profits or losses being realized then .

A company with a long position in Swiss francs, owing 500,000 Sfr, can purchase futures contracts to potentially offset exchange rate losses by locking in current rates. By purchasing four futures contracts in 125,000 Sfr increments at a set initial margin, the company adjusts its margin daily to maintain positions, thus hedging against fluctuations in the spot exchange rate .

In currency futures trading, a margin account requires traders to maintain a balance above a specified maintenance level, cushioning against daily market volatility. When account balances fall below this level due to adverse price movements, funds must be added to avoid liquidation, thus protecting against sustained losses .

Currency futures options allow profits through the exercise of the option when the exchange rate is favorable, thus limiting loss to the premium paid; conversely, direct currency futures involve daily settlement and can lead to ongoing profits or losses as market values fluctuate, offering more immediate cash flow impacts .

According to the expectations theory of the term structure of interest rates, a downward-sloping yield curve indicates that bond market traders anticipate a decrease in future short-term interest rates. This decrease is reflected in the average of current and forecasted future short-term rates plus any term premium for longer maturities, which collectively fall below the current short-term rate .

The break-even point for a currency option is found by equating the cost of the option with potential gains, such as $0.9988/€. This break-even informs strategic financial decisions by indicating the minimum price movement needed to cover the option's cost, guiding firms in selecting profitable hedging strategies .

The domestic real interest rate is calculated as 5% minus 2% yielding 3%, while the foreign real interest rate is 6% minus 4%, resulting in 2%. Real interest rates are not equal, so the real interest parity condition does not hold, prompting expected capital inflows into the domestic country and outflows from the foreign country until rates converge .

When choosing between forward contracts and swaps, a firm must consider aspects like counterparty alignment and desired exposure hedging. Forward contracts necessitate finding counterparties that agree on expected future conditions, whereas swaps more directly match traders needing currency exchanges, often with favorable loan rates by issuing debt in home rather than foreign currency .

Uncovered interest parity (UIP) states that the difference between the domestic and foreign interest rates (R - R*) should equal the expected rate of depreciation or appreciation of the domestic currency (i.e., (S+1 e – S)/S). When the left-hand side is negative, as in 5% - 6% = -1%, it indicates an anticipated appreciation of the domestic currency .

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