CHAPTER 7 Futures and Options on Foreign Exchange

CHAPTER 7 Futures and Options on Foreign ExchangeFutures Contracts: Some PreliminariesCurrency Futures MarketsInternational Finance in Practice: CME Ramping Up FOREX Support, Targets OTC BusinessBasic Currency Futures RelationshipsEurodollar Interest Rate Futures ContractsOptions Contracts: Some PreliminariesCurrency Options MarketsCurrency Futures OptionsBasic Option-Pricing Relationships at ExpirationAmerican Option-Pricing RelationshipsEuropean Option-Pricing RelationshipsBinomial Option-Pricing ModelEuropean Option-Pricing FormulaEmpirical Tests of Currency OptionsSummaryMINI CASE: The Options SpeculatorFutures Contracts: Some Preliminaries1 A CME contract on 125,000 with September deliverya) Is an example of a forward contractb) Is an example of a futures contractc) Is an example of a put optiond) Is an example of a call optionAnswer: b)Rationale: options trade on the CBOE2 Yesterday, you entered into a futures contract to buy 62,500 at $1.20 per . Suppose that the futures price closes today at $1.16. How much have you made/lost?a) Depends on your margin balanceb) You have made $2,500.00c) You have lost $2,500.00d) You have neither made nor lost money, yet.Answer: c)Rationale: You have lost $0.04, 62,500 times for a total loss of $2,500 = $0.04/ × 62,5003 In reference to the futures market, a “speculator”a) attempts to profit from a change in the futures priceb) wants to avoid price variation by locking in a purchase price of the underlying asset through a long position in the futures contract or a sales price through a short position in the futures contractc) stands ready to buy or sell contracts in unlimited quantityd) b) and c)Answer: a) 4 Comparing “forward” and “futures” exchange contracts, we can say that:a) They are both “marked-to-market” daily.b) Their major difference is in the way the underlying asset is priced for future purchase or sale: futures settle daily and forwards settle at maturity.c) A futures contract is negotiated by open outcry between floor brokers or traders and is traded on organized exchanges, while forward contract is tailor-made by an international bank for its clients and is traded OTC.d) b) and c)Answer: d)5 Comparing “forward” and “futures” exchange contracts, we can say thata) Delivery of the underlying asset is seldom made in futures contractsb) Delivery of the underlying asset is usually made in forward contractsc) Delivery of the underlying asset is seldom made in either contractthey are typically cash settled at maturity.d) a) and b)e) a) and c).Answer: d)6 In which market does a clearinghouse serve as a third party to all transactions?a) Futuresb) Forwardsc) Swapsd) None of the aboveAnswer: a)7 In the event of a default on one side of a futures trade,a) The clearing member stands in for the defaulting partyb) The clearing member will seek restitution for the defaulting partyc) If the default is on the short side, a randomly selected long contract will not get paid. That party will then have standing to initiate a civil suit against the defaulting short.d) a) and b) Answer: d)8 Yesterday, you entered into a futures contract to buy 62,500 at $1.20 per . Your initial performance bond is $1,500 and your maintenance level is $500. At what settle price will you get a demand for additional funds to be posted?a) $1.2160 per .b) $1.208 per .c) $1.1920 per .d) $1.1840 per .Answer: d)Rationale: To get a margin call, you have to lose $1,000. That will happen when the price FALLS (since youre buying euro) to $1.1840 per :$1.20/ $1.1840 per × 62,500 = $1,000.9 Yesterday, you entered into a futures contract to sell 62,500 at $1.20 per . Your initial performance bond is $1,500 and your maintenance level is $500. At what settle price will you get a demand for additional funds to be posted?a) $1.2160 per .b) $1.208 per .c) $1.1920 per .d) $1.1840 per .Answer: a)Rationale: To get a margin call, you have to lose $1,000. That will happen when the price RISES (since youre selling euro at $1.20 per .) to $1.2160 per :$1.2160/ $1.20 per × 62,500 = $1,000.10 Three days ago, you entered into a futures contract to sell 62,500 at $1.20 per . Over the past three days the contract has settled at $1.20, $1.22, and $1.24. How much have you made or lost?a) Lost $0.04 per or $2,500b) Made $0.04 per or $2,500c) Lost $0.06 per or $3,750d) None of the aboveAnswer: a)Rationale: Losses will happen when the price RISES (since youre selling euro at $1.20 per .) Total loss$1.20/ $1.24 per × 62,500 = $2,500Currency Futures Markets11 Todays 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 bea) $1,425b) $2,000c) $2,325d) $3,425Answer: c) not unlike Problem 1 at the end-of-chapter exercisesRationale: $2,325 = $2,000 + ¥12,500,000×(0.008011 0.008057) + (0.008057 0.007996) + (0.007996 0.007985) Please note that $0.8011/¥100 = $0.008011/¥ and $0.8057/¥100 = $0.008057/¥, etc.12 Todays 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 long 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) $1,425b) $1,675c) $2,000d) $3,425Answer: b) not unlike Problem 1 at the end-of-chapter exercises Rationale: $1,675 = $2,000 + ¥12,500,000×(0.008057 - 0.008011) + (0.007996 0.008057) + (0.007985 0.007996) Please note that $0.8011/¥100 = $0.008011/¥ and $0.8057/¥100 = $0.008057/¥, etc.Basic Currency Futures Relationships13 Open interest in currency futures contractsa) Tends to be greatest for the near-term contractsb) Tends to be greatest for the longer-term contractsc) Typically decreases with the term to maturity of most futures contractsd) a) and c)Answer: a)14 The “open interest” shown in currency futures quotations is:a) the total number of people indicating interest in buying the contracts in the near futureb) the total number of people indicating interest in selling the contracts in the near futurec) the total number of people indicating interest in buying or selling the contracts in the near futured) the total number of long or short contracts outstanding for the particular delivery monthAnswer: d)Eurodollar Interest Rate Futures Contracts15 The most widely used futures contract for hedging short-term U.S. dollar interest rate risk is:a) The Eurodollar contractb) The Euroyen contractc) The EURIBOR contractd) None of the aboveAnswer: a)16 Consider the position of a treasurer of a MNC, who has $20,000,000 that his firm will not need for the next 90 days:a) He could borrow the $20,000,000 in the money marketb) He could take a long position in the Eurodollar futures contract.c) He could take a short position in the Eurodollar futures contractd) None of the aboveAnswer: b)17 A DECREASE in the implied three-month LIBOR yield causes Eurodollar futures pricea) To increaseb) To decreasec) There is no direct or indirect relationshipd) None of the aboveAnswer: a)Options Contracts: Some Preliminaries18 If you think that the dollar is going to appreciate against the euroa) You should buy put options on the eurob) You should sell call options on the euroc) You should buy call options on the eurod) None of the aboveAnswer: c)19 From the perspective of the writer of a put option written on 62,500. If the strike price is $1.25/, and the option premium is $1,875, at what exchange rate do you start to lose money?a) $1.22/b) $1.25/c) $1.28/d) None of the aboveAnswer: a)Rationale: Per euro, the option premium is . Since its a put option, the writer loses money when the price goes down, thus he breaks even at $1.25/ $0.03/ = $1.22/20 A European option is different from an American option in thata) One is traded in Europe and one in traded in the United Statesb) European options can only be exercised at maturity; American options can be exercised prior to maturity.c) European options tend to be worth more than American options, ceteris paribus.d) American options have a fixed exercise price; European options exercise price is set at the average price of the underlying asset during the life of the option.Answer: b)21 An “option” is:a) a contract giving the seller (writer) the right, but not the obligation, to buy or sell a given quantity of an asset at a specified price at some time in the futureb) a contract giving the owner (buyer) the right, but not the obligation, to buy or sell a given quantity of an asset at a specified price at some time in the futurec) not a derivative, nor a contingent claim, securityd) unlike a futures or forward contractAnswer: b)22 An investor believes that the price of a stock, say IBMs shares, will increase in the next 60 days. If the investor is correct, which combination of the following investment strategies will show a profit in all the choices? (i) - buy the stock and hold it for 60 days (ii) - buy a put option (iii) - sell (write) a call option (iv) - buy a call option (v) - sell (write) a put optiona) (i), (ii), and (iii)b) (i), (ii), and (iv)c) (i), (iv), and (v)d) (ii) and (iii)Answer: c)Currency Options Markets23 Most exchange traded currency options a) Mature every month, with daily resettlement.b) Have original maturities of 1, 2, and 3 years.c) Have original maturities of 3, 6, 9, and 12 months.d) Mature every month, withOUT daily resettlement Answer: c)24 The volume of OTC currency options trading isa) Much smaller than that of organized-exchange currency option trading.b) Much larger than that of organized-exchange currency option trading.c) Larger, because the exchanges are only repackaging OTC options for their customersd) None of the aboveAnswer: b)25 In the CURRENCY TRADING section of The Wall Street Journal, the following appeared under the heading OPTIONS:Philadelphia Exchange PutsSwiss Franc69.3362,500 Swiss Francs-cents per unit Vol.Last68 May 12 0.3069 May 50 0.50Which combination of the following statements are true? (i)- The time values of the 68 May and 69 May put options are respectively .30 cents and .50 cents. (ii)- The 68 May put option has a lower time value (price) than the 69 May put option.(iii)- If everything else is kept constant, the spot price and the put premium are inversely related.(iv)- The time values of the 68 May and 69 May put options are, respectively, 1.63 cents and 0.83 cents. (v)- If everything else is kept constant, the strike price and the put premium are inversely related.a) (i), (ii), and (iii)b) (ii), (iii), and (iv)c) (iii) and (iv)d) ( iv) and (v)Answer: a) Rationale: Premium - Intrinsic Value = Time Value68 May Put: 0.30 Max68 - 69.33, 0 = 0.30 cents69 May Put: 0.50 Max69 - 69.33, 0 = 0.50 cents Currency Futures Options26 With currency futures options the underlying asset isa) Foreign currencyb) A call or put option written on foreign currencyc) A futures contract on the foreign currencyd) None of the aboveAnswer: c)27 Exercise of a currency futures option results ina) A long futures position for the call buyer or put writerb) A short futures position for the call buyer or put writerc) A long futures position for the put buyer or call writerd) A short futures position for the call buyer or put buyerAnswer: a)28 A currency futures option amounts to a derivative on a derivative. Why would something like that exist?a) For some assets, the futures contract can have lower transactions costs and greater liquidity than the underlying assetb) Tax consequences matter as well, and for some users an option contract on a future is more tax efficientc) Transactions costs and liquidity.d) All of the aboveAnswer: d)Basic Option-Pricing Relationships at Expiration29 The current spot exchange rate is $1.25 = 1.00 and the three-month forward rate is $1.30 = 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) $1.30 = 1.00b) $1.25 = 1.00c) $1.25 × (1+i$)3/12 = 1.00 × (1+i)3/12d) none of the aboveAnswer: b)30 The current spot exchange rate is $1.25 = 1.00 and the three-month forward rate is $1.30 = 1.00. Consider a three-month American call option on 62,500 with a strike price of $1.20 = 1.00. Immediate exercise of this option will generate a profit ofa) $6,125b) $6,125/(1+i$)3/12 c) negative profit, so exercise would not occurd) $3,125Answer: d)Rationale: with early exercise, you can pay $1.20 for something worth $1.25. So you make a nickel. Make a nickel 62,500 times and youve made $3,125.31 The current spot exchange rate is $1.25 = 1.00 and the three-month forward rate is $1.30 = 1.00. Consider a three-month American call option on 62,500 with a strike price of $1.20 = 1.00. If you pay an option premium of $5,000 to buy this call, at what exchange rate will you break-even?a) $1.28 = 1.00b) $1.32 = 1.00c) $1.20 = 1.00d) $1.38 = 1.00Answer: a)Rationale: A $5,000 option premium on 62,500 amounts to $0.08 per euro. With a strike price of $1.20 = 1.00 the exchange rate has to go to $1.28 = 1.00 for you to break even.32 Consider the graph of a call option shown at right. The option is a three-month American call option on 62,500 with a strike price of $1.20 = 1.00 and an option premium of $3,125. What are the values of A, B, and C, respectively?a) A = $3,125 (or $.05 depending on your scale); B = $1.20; C = $1.25b) A = 3,750 (or .06 depending on your scale); B = $1.20; C = $1.25c) A = $.05; B = $1.25; C = $1.30d) none of the aboveAnswer: a)33 Which of the lines is a graph of the profit at maturity of writing a call option on 62,500 with a strike price of $1.20 = 1.00 and an option premium of $3,125?a) Ab) Bc) Cd) DAnswer: b)American Option-Pricing Relationships34 The current spot exchange rate is $1.25 = 1.00; the three-month U.S. dollar interest rate is 2%. Consider a three-month American call option on 62,500 with a strike price of $1.20 = 1.00. What is the least that this option should sell for?a) $0.05×62,500 = $3,125b) $3,125/1.02 = $3,063.73c) $0.00d) none of the aboveAnswer: a)35 Which of the follow options strategies are consistent in their belief about the future behavior of the underlying asset price?a) selling calls and selling putsb) buying calls and buying putsc) buying calls and selling putsd) none of the aboveAnswer: c)36 American call and put premiums a) Should be at least as large as their intrinsic valueb) Should be at no larger than their moneynessc) Should be exactly equal to their time valued) Should be no larger than their speculative valueAnswer: a)37 Which of the following is correct?a) time value = intrinsic value + option premiumb) intrinsic value = option premium + time valuec) Option premium = intrinsic value time valued) Option premium = intrinsic value + time valueAnswer: d)European Option-Pricing Relationships38 Assume that the dollar-euro spot rate is $1.28 and the six-month forward rate is . The six-month U.S. dollar rate is 5% and the Eurodollar rate is 4%. The minimum price that a six-month American call option with a striking price of $1.25 should sell for in a rational market is:a) 0 centsb) 3.47 centsc) 3.55 centsd) 3 centsAnswer: c) footnote 3Rationale: Ca ³ Max(St - E), (F - E)/(1+r$), 0,Ca ³ Max($1.28 $1.25), ($1.2864 $1.25)/1.05½ , 0 = 3.55 cents You might consider partial credit for answer b), it is found byCa ³ Max($1.28 $1.25), ($1.2864 $1.25)/1.05 , 0 = 3.47 cents39 For European options, what of the effect of an increase in St?a) Decrease the value of calls and puts ceteris paribusb) Increase the value of calls and puts ceteris paribusc) Decrease the value of calls, increase the value of puts ceteris paribusd) Increase the value of calls, decrease the value of puts ceteris paribusAnswer: d)40 For an American call option, A and B in the graph area) Time value and intrinsic valueb) Intrinsic value and time valuec) In-the-money and out-of-the moneyd) None of the aboveAnswer: b)Rationale: Exhibit 7.1041 For European options, what of the effect of an increase in E?a) Decrease the value of calls and puts ceteris paribusb) Increase the value of calls and puts ceteris paribusc) Decrease the value of calls, increase the value of puts ceteris paribusd) Increase the value of calls, decrease the value of puts ceteris paribusAnswer: c)42 For European currency options written on euro with a strike price in dollars, what of the effect of an increase in r$ relative to r?a) Decrease the value of calls and puts ceteris paribusb) Increase the value of calls and puts ceteris paribusc) Decrease the value of calls, increase the value of puts ceteris paribusd) Increase the value of calls, decrease the value of puts ceteris paribusAnswer: d)43 For European currency options written on euro with a strike price in dollars, what of the effect of an increase in r$?a) Decrease the value of calls and puts ceteris paribusb) Increase the value of calls and puts ceteris paribusc) Decrease the value of calls, increase the value of puts ceteris paribusd) Increase the value of calls, decrease the value of puts ceteris paribusAnswer: d)44 For European currency options written on euro with a strike price in dollars, what of the effect of an increase r?a) Decrease the value of calls and puts ceteris paribusb) Increase the value of calls and puts ceteris paribusc) Decrease the value of calls, increase the value of puts ceteris paribusd) Increase the value of calls, decrease the value of puts ceteris paribusAnswer: c)Binomial Option-Pricing Model45 The hedge ratio a) Is the size of the long (short) position the investor must have in the underlying asset per option the investor must write (buy) to have a risk-free offsetting investment that will result in the investor perfectly hedging the option.b)c) Is related to the number of options that an investor can write without unlimited loss while holding a certain number of shares. d) All of the above.Answer: d)Rationale: a) and b) are straight out of the book; c) is true (its also a pretty mild statement) but not explicitly stated in the book, but a good student would know that if a) and b) are true, then the right answer must be d).46 Find the value of a call option written on 100 with a strike price of $1.00 = 1.00. In one period there are only two possibilities: the exchange rate will move up by 15% or down by 15%