CURRENCY FUTURES

AND OPTIONS MARKETS

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CHAPTER OVERVIEW
I. FUTURES CONTRACTS
II. CURRENCY OPTIONS

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Outline
Meaning of Futures
Features of Futures Contracts
Using Futures for Hedging and
Speculation
Meaning of Forwards
Features of Forward Contracts
Using Forwards for Hedging and
Speculation
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Definition
A futures contract is an exchange-
traded, standardized, forward-like
contract that is marked to the market
daily. This contract can be used to
establish a long (or short) positioning
the underlying asset.

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Futures Contracts
A futures contract is an agreement to buy or
sell a specified quantity of a specified asset at
a certain point in the future at a price agreed
upon today
In the case of currencies, it is an agreement
to buy/sell a specified quantity of a specific
currency at a pre agreed upon exchange rate
at a certain time in the future

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Currency Futures
Trade on an organized exchange
Futures contracts are standardized with
regard to the following
The asset on which you trade a futures contract
The contract size
Delivery arrangements
Daily price movement limits-limit up and limit
down
Position limits
Mark to Market on a daily basis

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Corporate Use of Currency Futures
Hedge open positions in foreign currencies by
buying/selling currency futures
Foreign currency cash inflows
Risk: domestic currency may appreciate
Strategy: sell foreign currency in the futures market at
the futures exchange rate (Short)
Foreign currency cash outflows
Risk: domestic currency may depreciate
Strategy: buy foreign currency in the futures market at
the futures exchange rate (Long)

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Short position – if a bank buys less of a
currency that it contracts to sell. Eg:
Import – short- purchase of foreign
currency
Long Position - If a bank buys more of a
currency than it contracts to sell eg: export
– Long – Sale of foreign currency
Square position – when quantum of sale and
purchase is equal.

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Forward Contracts
Agreement to buy or sell an asset at a certain
time in the future for a predetermined price
Over-the-counter product that do not trade
on any organized exchange
Delivery date can be any date that is mutually
convenient to both the parties to the contract
Size can be customized
Not marked-to-market daily

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Hedging and Speculation using
Forwards
Expect a currency to appreciate
Buy that currency forward (Long Position)
Expect a currency to depreciate
Sell that currency forward (Sell Position)
Profit/Loss in a long position:
ST – K
Profit/Loss in a short position:
K – ST
Where ST is the spot exchange rate at maturity and K is
the forward exchange rate at which you buy/sell a
currency forward.
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PART I.
FUTURES CONTRACTS
I. CURRENCY FUTURES
A. Background
1. 1972: Chicago Mercantile
Exchange
opens International Monetary
Market. (IMM) for trading currency futures

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 FUTURES CONTRACTS
2. IMM provides
a. an outlet for hedging currency risk with futures
contracts.
b. Definition of futures contracts:
contracts written requiring
• a standard quantity of an available currency
• at a fixed exchange rate
• at a set delivery date.
Four value dates of contracts: the third Wednesday in March, June,
September, and December.
Delivery of the underlying foreign currency occurs 2 business days if held
to maturity.
Currency Futures Quotations based on US dollar equivalent terms
Price of contract = contract size × exchange rate
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FUTURES CONTRACTS
c.Available Futures Currencies:

1.) British pound 5.) Euro

2.) Canadian dollar 6.) Japanese yen
3.) Deutsche mark 7.) Australian dollar
4.) Swiss franc
Size & Maturity of the Contract:
Fixed Maturity, Limted size -7. and it is standardised, a
fixed amount of different currencies

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FUTURES CONTRACTS
d. Standard Contract Sizes:
contract sizes differ for each of the 7
available currencies.
Examples:
Euro = 125,000
British Pound = 62,500

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FUTURES CONTRACTS
e. Transaction costs:
payment of commission to a
trader
f. Leverage is high
1.) Initial margin required is
relatively low (e.g. less than
.02% of sterling contract
value).
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FUTURES CONTRACTS
g. Maximum price movements
1.) Contracts set to a daily
price limit restricting
maximum daily price
movements.

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FUTURES CONTRACTS

2.) If limit is reached, a margin

call may be necessary to

maintain a minimum margin.

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FUTURES CONTRACTS
h. Global futures exchanges that
are competitors to the IMM:
1.) Deutsche Termin Bourse
2.) L.I.F.F.E.London International
Financial Futures Exchange
3.) C.B.O.T. Chicago Board of Trade

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FUTURES CONTRACTS
4.) S.I.M.E.X.Singapore International
Monetary Exchange
5.) H.K.F.E. Hong Kong Futures Exchange

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FUTURES CONTRACTS
B. Forward vs. Futures Contracts
Basic differences:
1. Trading Locations6. Settlement Date
2. Regulation 7. Quotes
3. Frequency of 8. Transaction
delivery costs
4. Size of contract 9. Margins
5. Delivery dates 10. Credit risk

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 Organization of Futures Markets
 Investors must establish a commodity or margin account in order to trade futures
contracts
 Margin requirements are between 5 and 10 percent of the value of the position
 Futures markets are subject to daily limits on price fluctuations
 Investors in futures may also be subject to position limits
 In a Future market – brokers strike the deals sitting face –face under a trading roof
known as Pits.
 Brokers can trade for themselves or for customers
 Trade for themselves – they are called locals or floors traders.
 Brokers trade on behalf of customers – commission brokers or floor brokers. They
charge commission from their clients.
 Traders acting for themselves as well as on behalf of customers are dual traders.
 They act more for their benefit and not for clients. Such favorable treatment for their own
account at the expense of clients is known as front running.

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 Locals – 1. Scalpers who hold their
position – long or short – for not more than
few minutes. Profit out of volume trading
2. Day Traders- who hold position for
long period that is less than a full
trading session.
3. Position Traders- hold a position for
a period ranging from overnight to a
week or a month.

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Transactions through a clearing house
Trading in currency futures is subject to specific
margin and maintenance requirements.
To cover risk – deposit margin money with clearing
house is in form of cash deposits or liquid securities.
Initial margin- varies from one excahnge to other.
Returned on completion of contract. Fwd contracts-no
margin money.
2 margin money –
1. Initial margin- deposited at time of signing contract
2. Maintenance Margin- minimum level to which
margin is allowed to fall in the sequel of loss. If
balance drops below this additional amount as
variation margin is deposited

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Marketing to Market
 Marking to market – rates are matched every day
with the movements in spot rates: and on this basis
gains and losses are settled everyday. This process is
marking to the market.
 the futures markets elaborate system of daily
adjustments of contract prices and margin accounts
 Neither party deals directly with each other
 On futures exchanges, almost 90 percent of all
positions are closed out before they mature

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Characteristics Forward Contract Future Contract
Size Tailored to individual need Standardised
Maturity Tailored to individual need Standardised
Method of Transaction OTC Deal Dealing on the floor of the
exchange
Commission Spread between banks – Brokerage fee
busying and selling price
Security Deposit Not Required Margin Money –deposited
to clearing House
Clearing Operation No Clearing House Clearing House for daily
settlement
Access Limited to very large Open to anyone who needs
customers who deal in hedging or speculation
foreign trade
Regulation Self regulating Regulatedby rules of the
stock exchange
Liquidation Mostly settled by actual Mostly settled by offsetting
delivery contract and few by
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FUTURES CONTRACTS
Advantages of futures: Disadvantages of futures:
1.) Smaller 1.) Limited to 7
contract size currencies
2.) Easy liquidation 2.) Limited dates
3.) Well- organized of delivery
and stable 3.) Rigid contract
market. sizes.

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Features of futures contracts:

• Standardized contracts:
(1) underlying commodity or asset
(2) quantity
(3) maturity.
• Exchange traded
• Guaranteed by the clearing house — no
counter-party risk
• Gains/losses settled daily
• Margin account required as collateral to cover
losses.
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 Types of Orders
Limit Order- stipulates a particular price at which deal
is to be made
Fill-or-kill – commission broker is instructed to fill an
order immediately at a specific price. The order is
cancelled if it is not transacted quickly
All-or-none – commission broker transacts different
parts of the deal at different prices
On-the-open – transaction within few minutes of
opening the stock exchange
On –the –close – transacting during the closure of the
stock exchange
Stop order – reversing trade when the price hits a
prescribed limit. Purpose is to protect against losses
on existing position. 28
Costs in Future deal
Brokerage commission – charged by
commission brokers and covers both
opening and reversing trade
Floor trading and clearing fee – charged
by stock exchange and its associated
clearing house.
Delivery cost- delivery of currencies (it
is not common)

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Hedges and Speculators
 Hedgers – traders who open futures positions to
manage risk that arises from other businesses
 hedgers:
 are in the market to buy insurance
 Speculators – investors who open futures positions
expecting to close them again at more advantageous
prices
 speculators:

provide liquidity to the market and increase efficiency

are in the market to make money

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 PRINCIPLE OF HEDGING
One way to manage these risks and uncertainties is to enter into
transactions that expose the entity to risk and uncertainty that fully or
partially offsets one or more of the entity’s other risks and
uncertainties, transactions known as ‘hedges’.
The instrument acquired to offset risk or uncertainty is known as
‘hedging instrument’ and the risk or uncertainty hedged is known as
‘hedged item’.
There are predominantly two motivations for a company to hedge:
To lock-in a future price which is attractive, relative to an
organisation’s costs.
To secure a commodity price fixed against an external contract

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A hedger is an individual who enters the futures
market in order to reduce a preexisting risk.
A preexisting position might include:
1. A commodity that you own: you have a silver mining
company and have silver stored. You own the commodity.
2. An anticipatory hedge: a commodity that you will acquire in
the future. If you are a new silver mining company and just
have initiated mining operations. You expect to acquire/have
silver in the future.
3. An anticipatory hedge: a commodity that you will need in
the future. You are a manufacturer of film, and silver is an
essential input for film production. You will need to acquire
silver to produce the film for next year sales.
Each of these positions can be hedged.

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The hedge horizon is the amount of time that
you need to protect the price (hedge) for.
In some instances, you will have a predefined
hedging horizon. The silver mining company
has just started mining the silver ore. The
process of going from mining to refined silver
takes 15 months. The silver mining company
may wish to hedge until the silver is mined
and refined.
In other instances, there will be no specific
hedging horizon.
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A Long Hedge: A long hedge involves
purchasing a futures contract.
A Short Hedge: A short hedge involves selling a
futures contract to reduce risk.
Hedgers, as a group, need speculators to take
positions and bear risk only for the mismatch in
contracts demanded by long and short hedgers.
If long and short hedgers had exactly offsetting
needs, hedgers would not need speculators.

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 Cross Hedge
In many cases, there will not be a futures contract
available that exactly matches our needs. In this case,
we need to engage in a cross-hedge.
A cross-hedge is needed when the characteristics of
the spot and futures positions do not match perfectly.
Some of the mismatches are:
Maturity: the hedging horizon may not match the futures
expiration date.
Quantity: the quantity to be hedged may not match the
futures contract quantity.
Quality: the physical characteristics of the commodity to be
hedged may differ from the characteristics required for
futures contract.
Cross Hedge: The act of hedging ones position by
taking an offsetting position in another good with
similar price movements.

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 Micro-Hedging
Micro-hedging occurs when a futures position is
matched against a specific asset or liability
item on the balance sheet.

Macro-Hedging
Macro-hedging occurs when a hedge is
structured to offset the net risk associated
with the hedger’s overall asset/liability mix.

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Strip Hedge
Strip hedging occurs when a trader enters the
futures market and takes a series of futures
positions of successively longer expirations.
Stack Hedge
Stack hedging occurs when a trader enters
the futures market and takes a number of
positions that can be stacked in the front
month and then rolled forward.

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 Hedging in Currency Futures market
Delta Hedge: An options strategy designed reduce the
risk associated with price movements in the
underlying security, achieved through offsetting long
and short positions.
Delta Cross Hedge: A hedging technique employed
when there is a mismatch between both the maturities
and the currencies of two securities. Because the
hedge trader wants to use one of the securities to
offset the risk of the other, the two mismatches can
cause calculation complications. The trader seeks to
offset the percentage change in the currency of one of
the underlying securities with the percentage change
in the value of a futures contract on the other
security. 38
 Speculation with Currency Futures
Speculators make use of the currency futures for reaping
profits.
If particular currency spot rate is expected to appreciate
beyond those mentioned in the contract, they buy currency
futures denominated in that particular currency.
Spot rate: USD = Rs.50.20
•1 month future rate: USD = Rs.50.40
•Expected spot rate on maturity: USD = Rs. 50.65
•Dealer buys 100 lots of currency futures contract (100,000
USD)
•Value of contract: Rs.50,40,000; Margin deposit: Rs.5,40,000
•If exchange rate move up to Rs.50.65 as anticipated, dealer
gains profit of Rs.15,000 (100,000* Re.0.15)
•Rate of return: (15000/5,40,000)(12)(100) = 33.33%

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Intra Currency Spread : Speculators buy and
sell futures of the same currency for 2 delivery
dates if the rates for the two dates differ. This
is known as intra-currency spread.
Inter Currency Spread: it occurs when the deal
involves purchase and sale of future contracts
with the same delivery date but with 2 different
underlying currencies.

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 Futures contracts can be divided into
two broad categories:
1. commodities – agricultural, metal,
and energy-related products
2. financials – foreign currencies, debt
and equity instruments

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Basic Concepts
 Commodity futures contract – when the
underlying asset is a real commodity
 Financial futures contracts – when the
underlying asset is a financial obligation such
as currency, bond, or stock portfolios
 Futures price – is the price set out in a
futures contract
 Settle price – the price at which the market’s
books were balanced at the end of the day’s
trading
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 Organized exchanges are crucial to the usefulness of
futures contracts as risk-management tools
 Futures trade on:

WCE, ME (Canada)

CME, NYCE, NYME, NYFE (US)
 Futures contracts have maturities of less than seven
years
 Futures contracts are standardized
 Marginal rate of substitution is the rate at
which a consumer is ready to give up one good
in exchange for another good while maintaining
the same level of satisfaction.

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 Future Prices, Forward Prices and
Expected Spot Prices on Delivery
Conditions of Risk-neutrality: -forward prices, futures
prices and expected spot prices at delivery are equal
under the conditions of risk-neutrality., utility function
is linear and co-variance between marginal rate of
substitution and exchange rate at delivery is Zero.
Conditions of risk aversion: investors are risk-averse,
interest rates is not constant, hence future prices are
not equal to forward prices.
1. Settlement procedure is different
2. Interest rates are not constant.
3. Different types of premium are there in currency
future prices . It is a sum of currency forward price,
term premium, reinvestment premium.
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Term Premium: arises from the existence of liquidity
premium involved in the term structure of the
contract. The shorter the maturity, the greater is the
liquidity. Premium is constant across currencies.
Reinvestment rate premium: margin earned on the
daily settlement of the futures contract. Higher
interest rate, greater is the premium. Vary across
different currencies.
Hedging premium: depends upon co-variance between
exchange rate at delivery and investors marginal rate
of substitution. It may be positive with the result that
the forward rate will be greater than expected spot
rate at delivery. This position is known as contango.
When co-variance is negative it is normal
backwardation.
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Commodity Futures Prices

 The Expectations Hypothesis

 states that future prices of a commodity should be what traders
expect the spot price to be in the future
 The Net Hedging Hypothesis
 Normal backwardation – when a futures market has a shortage
of hedgers in long positions which means the futures contract
price will fall below the spot price expected in the future (F 
E(S))
 Normal forwardation – a futures market with a shortage of
hedgers on the short side of the contract which causes the
future price to exceed the expected spot price (F > E(S))

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 Commodity Futures Arbitrage
 when futures contracts approach maturity the
futures price equals the spot price, otherwise an
arbitrage situation occurs
 For assets that are not maturing, arbitrageurs
set limits on the difference between the futures
prices and the current spot prices known as
“boundaries”

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 The boundaries formula is: F  S(1 + r)t + ct
where:
F = future price
S = spot price
r = annual risk-free interest rate
t = time until maturity of the futures contract
measured in years
c = annual storage, insurance, transportation for
carrying an inventory of underlying assets
 When the futures prices exceeds the upper
limit there is a arbitrage situation
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Financial Futures Prices
 Foreign currency futures:
 allow one to lock in an exchange rate at a
specified point in the future
 are available in all major currencies
 are valuable risk-management tools for
firms that engage in international business
 Foreign currency exposure – the term used
when a business has a net contractual
obligation in a foreign currency

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 Interest rate forward and futures contracts allows
one to lock in a price at which a debt instrument is to
be bought or sold in the future
 Interest rate futures should be considered when:
1. Borrowers want to protect against future interest rate
increases
2. Investors want to protect against future interest rate
decreases
3. Financial institutions are exposed to interest rate risk
4. Speculators want to bet on interest rates moving in a
particular direction

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 Stock index futures:
 allows one to lock in a future price at which
one can buy the portfolio of stocks that
make up a stock market index are for
specified amounts of underlying assets are
settled in cash

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Financial Future prices
 Program trading – when institutions use
direct computer links to stock
exchanges to assemble large portfolios
of stocks that are based on theoretical
equivalence of positions
in index futures and their
underlying stocks

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 PART II
CURRENCY OPTIONS
I. OPTIONS
A. Currency options
1. Offer another method to hedge exchange
rate risk.
2. First offered on Philadelphia Exchange
(PHLX). In dec 1982
3. Fastest growing segment of the hedge
markets.
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 CURRENCY OPTIONS
4. Definition:
a contract from a writer ( the seller) that gives the right
not the obligation to the holder (the buyer) to buy or sell a
standard amount of an available currency at a fixed exchange
rate for a fixed time period.
For every option there is both a buyer and a writer
The buyer pays the writer for the ability to choose when to
exercise, the writer must abide by buyer’s choice
Buyer puts up no margin, naked writer must post margin

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 Broad Features
Buyer of currency options has the freedom to
exercise the option if the agreed upon rate
turns in his favour.
Thus it is his right and not obligation to
exercise an option.
For this he has to pay a premium to the option-
seller.

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 Types of options market
Listed Currency option market:
1. Trading was initially done on british pounds but later other currencies
were added.
2. They are standardised contracts
3. Clearing house is essentially part of the contract. And it charges a fee
from both sides. For option buyer – clearing house is a seller of option
and vs.
4. Margin money is deposited by the writer to the clearing house equally to
the current market price of the option along with a specific percentage of
the underlying curency value.
5. Maturity is fixed in the market and expiration months are march, june,
september and december.
6. Expiration day is Friday preceding the third Wednesday of the expiration
month.
7. Trading process begins when customer places an order with a broker
who is a member of the exchange.
8. Offers are made by specialists or market makers or floor brokers acting
as agents for other customers.

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 Over-the-counter market or inter bank currency option
market:
1.It is located at Newyork and London and size of
transactions is many times that of the market in the
organised exchanges.
2. Amount involved is larger
3. European options are usually found in OTC market,
american options in organised exchanges.
4. Number of currencies in OTC market is larger
5. Size of contract is standardised
6. Commercial Banks or Investment banks write the
options for the clients and not clearing house.
OTC- 2 tier -1. retail market – non bank customers
2. Wholesale market – between banks.
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Currency Future options market
mixture of currency futures and options.
But basically options market as they have the
option to either exercise or let it expire.
Buyer and seller of options have to Deposit a
margin money equal to contract price.
They are marked to market – daily settlement
is undergone.

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 Types of options
2 types 1. Call Option – buyer of the option
agrees to buy the underlying currency.
2. Put Option -buyer of the option agrees to sell
the underlying currency.
Call and put option are also two types –
1. European Option- only on maturity
2. American option – exercised even before
maturity. Buyer interest to exercise the
option before maturity. Commands higher
prices than europen option.

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1. Forward reversing option: call option premium is
paid only when the spot rate is below a spacified
level. Premium is quoted by the seller who charges
only when it is exercised.
2. Preference options: buyer gets an additional
privilege to designate the option either as a call or
as a put.
3. Average rate options: arithmetic average of the spot
rate during the life of the option that is taken into
account at maturity instead of the spot rate. Hedge
a series of cash flows over a period in one single
contract. If avg rate on maturity < strike price –
buyer gets the difference between the two. If >
then he lets the option expire.
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Look back option: holder has the right to purchase or
sell foreign currency at the most favorable exchange
rate realised over the life of the option.
Cylinder or tunnel option: two strike rates exist. Spot<
lower strike rate – buyer pays lower strike rate.Spot
rate > than higher strike rate – he pays higher strike
rate.
Barrier options:
Down-and-out option: option expires automatically if spot
rate reaches a level mentioned in the contract.
Down and in option: when spot rate reaches a specified
barrier within expiry date.
Basket Option: caters to buyers who are confronted with
foreign exchange risk in respect of many currencies.
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 Options Terminology
Option Buyer: A person or a firm who gets the
right to buy options, is known as option –
holder.
Option Seller: the party having obligation to
perform if option is exercised or the party who
charges the premium for granting such
privilege to the buyer is known as option writer.
Call Option: an option bought by an option for
buying a particular currency.
Put Option: an option bought by an option for
sell a particular currency. 62
CURRENCY OPTIONS
Exercise Price
a. Sometimes known as the
strike price.
b. the exchange rate at
which the option holder
can buy or sell the
contracted currency.
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CURRENCY OPTIONS
Status of an option
a. In-the-money- would be worth something if exercised
now. In the below situation if he exercises he will gain
Call: Spot > strike
Put: Spot < strike
b. Out-of-the-money - would be worthless if exercised now
Call: Spot < strike
Put: Spot > strike
c. At-the-money
Spot = the strike on the maturity date.

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 CURRENCY OPTIONS
The premium or option value or option price: value or the price of an option that the writer
charges the buyer at the time of signing the contract. It is not refundable.
Intrinsic Value: denotes the extent to which an option would currently be profitable to exercise. It
represents the gains accruing to the holder on the exercise of the option.
Icall = S>X where s- spot rate and x- strike price
Iput = S<X
Intrinsic value can be positive or zero but not negative because the buyer will not exercise the
option if it is out-the-money.
Time Value: represents the sum of money that a buyer is willing to pay over and above the intrinsic
value.
It exist between spot rate of the underlying currency is expected to move towards in-the-money
position between signing and maturity of the contract. On maturity time value is zero and
premium is the intrinsic value.
At-the money – no intrinsic value option premium is entirely the time value.

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 Gains or Losses of the option traders
Option buyer - Gains are unlimited but loss is limited
to amount of premium paid.
Option seller- loss is unlimited and gain limited to
the premium paid.
1. Call Options: the buyer will gain if spot price is
greater than the strike price along with the premium
C.
Buyer’s gain = S – X – C
2. Put Option: the buyer will let the option expire if the
spot rate is greater than the strike rate. The buyer
will be put to a loss equilavent to the premium and
profit will accre to buyer if spot < strike by more
than amt of premium.
Buyer’s gain = X – S - C
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 Options Pricing
The value of an option, which is known as the
premium, is equal to the sum of its intrinsic
value and time value.
Factors which influence value of an option are
Changes in forward rates
Changes in spot rates
Time to maturity
The degree of volatility in exchange rate
Interest rate differential
Alternative strike price
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Changes in Forward rates: forward rates are central to
option pricing, and so changes in forward rates
influence the pricing of an option.
Changes in spot rates: changes in spot rates influence
the option prices.
At-the-money position, the intrinsic value is zero and entire
premium is represented by the time value.
Out-the-money position, the intrinsic value is zero, but
cannot be negative, because option will not be exercised.
In-the-Money intrinsic value will emerge and premium pais
partly of intrinsic value and partly of time value.
The extent of change in the premium due to change in spot
rate is represented by delta(δ) = change in premium/change
in spot rate

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 Time to maturity : the longer the time to
maturity, the greater is the option’s value. The
impact of change in time to maturity on option
value is represented by theta.
Theta (θ )= Change in premium/ change in
time.
Theta represents an exponential, and not a
linear, relationship between time and maturity
and value of an option.

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Volatility in exchange rates: volatility is
expressed as the standard deviation of daily
percentage change in the spot rate of the
underlying currency. It is per annum %.
The larger the volatility, the larger is the
chance for the spot rate moving into the in-the-
money zone and greater is the value of option.
The impact of volatility on option value is
expressed by vega.
Vega= change in premium/change in volatility.
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Sensitivity to varying Interest rate differential:
Interest rate differentials lead to a change in
forward rate and changes in interest rate will
also cause changes in value of option. Impact
of changes in domestic interest rate on option
value is expressed by rho and impact of change
in foreign interest rate on option value is
expresses by phi.
If domestic interest rates rises, value of option
will improve.
If foreign rate increases, value of option will
fall.
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Changing strike price: leads to a change in
intrinsic value and thereby in value of an
option.
In call option: if strike price falls with spot rate
being constant, intrinsic value will be larger and
option price will be higher.
In put option: if strike price falls with spot rate
being constant, intrinsic value will be lower and
option price will also fall.

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CURRENCY OPTIONS
B. When to Use Currency Options
1. For the firm hedging foreign
exchange risk

a. With sizable unrealized gains.

b. With foreign currency flows
forthcoming.

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CURRENCY OPTIONS
2. For speculators
- profit from favorable
exchange rate changes.

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 Hedging with Currency Options
Hedging through purchase of options: in case of
direct quote : importers buy call option and
exporters buy a put option.
Buying of currency options is preferred only
when strong volatility in the exchange rate is
expected and if volatility is only marginal,
forward market hedging is preferred.
Hedging through selling of options: when
volatility in exchange rate is expected to be only
marginal. Importer sells a put option and
exporter sells a call option.
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Tunnels: simultaneously purchase and sale of
options. – an importer buys a call and sells a
put option. Exporter buys a put and sells a call.

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 Speculating with options
Purchase of Options: Speculators make profit
out of purchase of currency options.
They normally buy call when they expect
upward movement in the value of the currency.
On expiry, buy at agreed rate and sell in open
market at higher rate.
They buy put when they expect depreciation of
the currency.
Complicated deals like Mixture of two calls or
two puts or one call and other put.
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Spreads: speculators combine 2 calls or 2 puts.
In case of 2 calls/puts, one is sold and other
purchased. If expiry is same for both but strike
prices are different , it is vertical spread.
When strike price same but expiry differs –
horizontal spread.
When expiry and strike price for both calls
differs –diagonal spread.

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 Vertical spread on call combinations: may be
bullish or bearish. Bullish- generates profit
when rates move upward and vice versa for
bearish.
Bullish vertical spread strategies-
1. purchase of in-the-money call and sale of out-
of the money call.
2. Buy an in-the-money call and sell another in-
the-money call with higher strike price.
Bearish vertical spread strategies – purchase
call with a strike price below spot rate and sell
another with lower strike price.
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Horizontal spread on call combinations: strike price
may be the same but spot rate may vary between 2
expiry dates and so sale and purchase of 2 calls mey
give different profit to the speculator.
Diagonal Spread on call combinations: it is a
combination of horizontal and vertical spread.
Speculator buys a call with relatively long maturity and
sells another with short maturity and high strike price.
If spot rate moves up and is greater than strike rate of
first call, first call will be exercised and speculator as
an option buyer will reap profits.

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Spreads on combination of puts: in bullish vertical
spread – speculator buys one and sells another put
with same maturity but low strike price. Variants are:
Sometimes, both strike price are higher than the spot
rate. In the other, price of the bought put is higher
than spot rate but price of the sold put is lower.
If strike rate of the bought put is higher than the spot
rate , option will be exercised and speculator will gain.
In bearish vertical spread- speculator buys one put and
sells another put with 2 strike prices.
In horizontal spread- buys put with longer maturity
and sells one with shorter maturity.
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Combination of Calls and puts:
1. Straddles – 2 options have the same strike price and same
expiry date.
2. Strangles: when strike price and maturity differ in case of
2 options of the combination
Straddles: is used when exchange rate is expected to
change suddenly and in a big way.
Strangles: buy strangles: the speculator buys one call
and one put with different strike rates with different
maturity.
Sell strangles: sell one call and one put but with
different strike rates with different maturity.
The differnce in strike rates and in premium depending
on maturity is the gain to the speculators. 82
 Various combination of
options:
Tunnel for importers Buying call and selling put
Tunnel for exporters Buying put and selling call
Vertical spread : Call Buy one call and sell another call with
same expiry and different strike price
Vertical spread : put Buy one put and sell another put with
same expiry and different strike price
Horizontal spread : Call Buy one call and sell another call with
same strike price and different expiry
Horizontal spread : put Buy one put and sell another put with
same strike price and different expiry
Diagonal spread : Call Buy one call and sell another call with
different expiry and strike price
Diagonal spread : put Buy one put and sell another put with
different expiry and strike price

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Buying of Straddles Buy a call and buy a put
with same expiry and strike
price
Selling of Straddles sell a call and sell a put
with same expiry and strike
price
Buying of strangles Buy a call and buy a put
with different expiry and
strike price
Selling of strangles sell a call and sell a put
with different expiry and
strike price
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CURRENCY OPTIONS
Market Structure
1. Location
a. Organized Exchanges
b. Over-the-counter
1.) Two levels
retail and wholesale
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