CHAPTER 7 FUTURES AND OPTIONS ON FOREIGN EXCHANGE

ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS
1. Explain the basic differences between the operation of a currency forward market and a
futures market.
Answer: The forward market is an OTC market where the forward contract for purchase or sale
of foreign currency is tailor-made between the client and its international bank. No money
changes hands until the maturity date of the contract when delivery and receipt are typically
made.

A futures contract is an exchange-traded instrument with standardized features

specifying contract size and delivery date. Futures contracts are marked-to-market daily to
reflect changes in the settlement price. Delivery is seldom made in a futures market. Rather a
reversing trade is made to close out a long or short position.
2. In order for a derivatives market to function most efficiently, two types of economic agents
are needed: hedgers and speculators. Explain.
Answer:

Two types of market participants are necessary for the efficient operation of a

derivatives market: speculators and hedgers. A speculator attempts to profit from a change in
the futures price. To do this, the speculator will take a long or short position in a futures contract
depending upon his expectations of future price movement.

A hedger, on-the-other-hand,

desires to avoid price variation by locking in a purchase price of the underlying asset through a
long position in a futures contract or a sales price through a short position. In effect, the hedger
passes off the risk of price variation to the speculator who is better able, or at least more willing,
to bear this risk.
3. Why are most futures positions closed out through a reversing trade rather than held to
delivery?
Answer: In forward markets, approximately 90 percent of all contracts that are initially established
result in the short making delivery to the long of the asset underlying the contract. This is natural
because the terms of forward contracts are tailor-made between the long and short. By contrast,

only about one percent of currency futures contracts result in delivery. While futures contracts are
useful for speculation and hedging, their standardized delivery dates make them unlikely to
correspond to the actual future dates when foreign exchange transactions will occur. Thus, they are
generally closed out in a reversing trade. In fact, the commission that buyers and sellers pay to
transact in the futures market is a single amount that covers the round-trip transactions of initiating
and closing out the position.
4. How can the FX futures market be used for price discovery?
Answer: To the extent that FX forward prices are an unbiased predictor of future spot exchange
rates, the market anticipates whether one currency will appreciate or depreciate versus another.
Because FX futures contracts trade in an expiration cycle, different contracts expire at different
periodic dates into the future. The pattern of the prices of these contracts provides information
as to the markets current belief about the relative future value of one currency versus another
at the scheduled expiration dates of the contracts.

One will generally see a steadily

appreciating or depreciating pattern; however, it may be mixed at times. Thus, the futures
market is useful for price discovery, i.e., obtaining the markets forecast of the spot exchange
rate at different future dates.
5. What is the major difference in the obligation of one with a long position in a futures (or
forward) contract in comparison to an options contract?
Answer: A futures (or forward) contract is a vehicle for buying or selling a stated amount of
foreign exchange at a stated price per unit at a specified time in the future. If the long holds the
contract to the delivery date, he pays the effective contractual futures (or forward) price,
regardless of whether it is an advantageous price in comparison to the spot price at the delivery
date. By contrast, an option is a contract giving the long the right to buy or sell a given quantity
of an asset at a specified price at some time in the future, but not enforcing any obligation on
him if the spot price is more favorable than the exercise price. Because the option owner does
not have to exercise the option if it is to his disadvantage, the option has a price, or premium,
whereas no price is paid at inception to enter into a futures (or forward) contract.
6. What is meant by the terminology that an option is in-, at-, or out-of-the-money?

Answer: A call (put) option with St > E (E > St) is referred to as trading in-the-money. If S t E
the option is trading at-the-money. If St < E (E < St) the call (put) option is trading out-of-themoney.

PROBLEMS - SEE END OF LECTURE SLIDES FOR PROBLEMS

1.

Yesterday, you entered into a futures contract to buy 62,500 at $1.50 per .
Your initial performance bond is $1,500 and your maintenance level is $500.
Below what settle price will be the first time you get a demand for additional
funds to be posted?
A. $1.5160
per .
B. $1.208
per .
C. $1.1920
per .
D. $1.4840
per .

Solution:
Alternative D.
Your performance bond must decrease in value from $1,500 to $500,00, therefore
with $1,000. Your initial futures contract value = $1.50 x 62,500 = $93,750. Since
you bought the Euros if the value of the $ per decrease, then you will make a
loss. Now question is . to what level must the value of the $ per decrease for
you to generate a loss of $1,000 and have to post additional funds? The value of
your contract should decrease to $92,750. Then calculate the value of $ per on
the decreased value of $92,750 = $92,750/62,500 = $1,4840.

2.

Yesterday, you entered into a futures contract to buy 62,500 at $1.50/. Your
initial margin was $3,750 (= 0.04 62,500 $1.50/ = 4 percent of the
contract value in dollars). Your maintenance margin is $2,000 (meaning that
your broker leaves you alone until your account balance falls to $2,000).
Below what settle price (use 4 decimal places) will be the first time you get a
margin call?
A. $1.4720
/
B. $1.5280
/
C. $1.500
/
D. None of the
above

Solution
Alternative A.
Your performance bond must decrease in value from $1,750 to $2,000,00. Your
initial futures contract value = $1.50 x 62,500 = $93,750. Since you bought the
Euros if the value of the $ per decrease, then you will make a loss. Now
question is . to what level must the value of the $ per decrease for you to
generate a loss of $1,750 and have to post additional funds? The value of your
contract should decrease to $92,000. Then calculate the value of $ per on the
decreased value of $92,000 = $92,0000/62,500 = $1,4720.

3.

Today's settlement price on a Chicago Mercantile Exchange (CME) Yen futures

contract is $0.8011/100. Your margin account currently has a balance of
$2,000. The next three days' settlement prices are $0.8057/100,
$0.7996/100, and $0.7985/100. (The contractual size of one CME Yen
contract is 12,500,000). If you have a short position in one futures contract,
the changes in the margin account from daily marking-to-market will result in
the balance of the margin account after the third day to be
A. $1,42
5.
B. $2,00
0.
C. $2,32
5.
D. $3,42
5.

Solution:
Alternative C.
You have a short position in 12,500,000. Thus you sold . If the value of the $
increase per , then you make a profit and vice-versa. In day one the value of the $
decreases and in days two and three the value of the $ per increases. In day one:
Decrease with .0046/100. Loss = -0.0046 x (12,500,000/100) =-$575.00. In day
two increase with 0.0061. Profit = 0.0061 x (12,500,000/100) =$762.50. In day
three increase with 0.0011. Profit = 0.0011 x (12,500,000/100) =$137.50.
Balance of margin account: $2,000 - $575,00 + $762.50 + $137.50 = $2,325.00

4 Suppose you observe the following 1-year interest rates, spot exchange rates and
. futures prices. Futures contracts are available on 10,000. How much risk-free
arbitrage profit could you make on 1 contract at maturity from this mispricing?

A. $159.
22
B. $153.
10
C. $439.
42
D. None of the
above

Solution:
Alternative A.
Compare futures price of dealer with own futures price that you calculate based on
IRP:
F360($/ = $1.45 x (1 +1.04)/ 1 x (1 + .03) = 1.4641
The futures price of $1.48/ is above the IRP futures price of $1.4641/ - it means
the forward value of the $ per is lower in the forward quote of the dealer than in
the IRP calculations (value of to high). Therefore, we want to sell (i.e. take a
short position in 1 futures contract on 10,000, agreeing to sell 10,000 in 1 year
for $14,800).
To hedge we will have to borrow $ at 4% interest, convert into , invest the at
3% and sell the at $1.48/1.
First question: How much do we have to buy now? Sufficient to increase to
10,000 when it has to be delivered in terms of forward contract. Therefore
discount 10,000/(1+0.03) = 9,708.74. Thus we need to borrow 9,708.74 x 1.45
= $14,077.67 to buy the 9,708.74 now.
At maturity, our investment matures and pays 10,000, which we sell for $14,800,
and then we repay our dollar borrowing with $14,640.78 ($14,077.67 x (1.04). Our
risk-free profit = $159.22 = $14,800 - $14,640.78.

5 The current spot exchange rate is $1.55 = 1.00 and the three-month forward
. rate is $1.60 = 1.00. Consider a three-month American call option on 62,500
with a strike price of $1.50 = 1.00. Immediate exercise of this option will
generate a profit of
A. $6,12
5.
B. $6,125/(1 +
i$)3/12.
C. negative profit, so exercise would
not occur.
D. $3,12
5.

Solution:
Alternative D.
The value of the option you can buy for $1.50 x 62,500 = $93,750. The value of
the 62,500 = $96,875. Profit = $3,125.

6.

The current spot exchange rate is $1.55 = 1.00 and the three-month forward
rate is $1.60 = 1.00. Consider a three-month American call option on
62,500. For this option to be considered at-the-money, the strike price must
be
A. $1.60 =
1.00
B. $1.55 =
1.00
C. $1.55 (1 + i$)3/12 = 1.00
(1 + i)3/12
D. none of the
above

Solution:
Alternative B.
An option can only be at the money when the spot price and strike prices are
exactly the same assume that no premium exists.