Summary: 1Ck80 - International & Strategic Risk Management

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• 3 Week 3

• 3.1 Chapter 7 Futures and Options on Foreign Exchange

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• Two properties of forward contracts:

  • Non-standard nature - highly customizable to needs of thebuyer and seller w.r.t. the commodities, amounts, deliverydates, settlements
  • OTC (Over the counter) - Not traded on any exchange 

• How is a futures contract like a forward contract?

  A futures contract is like a forward contract. It specifies that acertain currency will be exchanged for another at a specified time in the future at a price decided today.

• How is a futures contract different from a forward contract?

  It is different from a forward in that futures are standardized, traded on organized exchanges and are resettled daily via a clearinghouse.

• What are the standardizing features of a futures contract?

  • Contract size
    
  • Delivery date
  • Daily resettlement (or Market-to-market)

• What is the relationship between (currency) futures and forwards?

  • Both the foward and futures market are useful for price discovery
    
  • Both (should) show similar a trend
  • Futures can be priced similar to forwards using IRP model

• Difference between European vs. American options:

  • Exercise policy: European options can only be exercised onthe expiration date while American options can be exercised atany time up to and including the exercise date
  • Moneyness:
  • -If immediate exercise is profitable, an option is “in the money”- “Out of money” options can still have value

• How is the option pricing formula built?

  T = expiration time
  E = exercise price
  S_T = expiration date spot price
  c_0 = initial investment call
  p_0 = initial investment put
  C_aT =  value of the American call at expiration time T
  C_eT = value of the European call at expiration time T
  P_aT =   value of the American put at expiration time T
  P_eT =   value of the European put at expiration time T

• Option profit profiles (put)

  • If the put is in-the-money, it is worth E - S_T. The maximum gain is E - P_0
  • If the put in out-of-the-money, it is worthless, and the buyer of the put loses his entire investment of p_0

• Basic option pricing relationships; calls

  • At expiry, an American option is worth the same as an European option with the same characteristics
    
  • If the call is in-the-money, it is worth S_T - E
  • If the call is out-of-the-money, it is worthles

• European option-pricing relationships:

  
  The pricing boundaries for European options are more complex because they can only be
  exercised at expiration. There are two portfolios a US dollar investor could make:
  

  1.  Purchasing a European call option and lending/investing an amount equal to the present value of the exercise price of the exercise price at the US interest rate. The cost of this investment is: Ce + E/(1+r$).
  2. Lending the present value of one unit of foreign currency at the foreign interest rate. The cost of this investment is: St/(1+r).