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Unit 8: Currency Futures and Currency Options
Notes
Task On Monday morning, an investor takes a long position in a pound futures contract
that matures on Wednesday afternoon. The agreed-upon price is $1.70 for £62,000. At the
close of trading on Monday, the futures price rises to $1.72. At Tuesday close, the price
rises further to $1.73. At Wednesday close, the price falls to $1.71 and the contract matures.
The investor takes delivery of the pounds at the prevailing price of $1.71. Detail the daily
settlement process. What will be the investor’s profit (loss)?
Self Assessment
Fill in the blanks:
10. …………………… can be accomplished with either options or futures.
11. Gains and losses on open futures positions are limited only by the price of the
…………………… securities.
8.4 Currency Options
Foreign Currency Options are instruments that have assumed significant importance in recent
years. The awareness of this instrument’s potential can be traced back to at least 1978 when such
options were introduced by the newly established European Options Exchange (EOE) of
Amsterdam. Most of the EOE’s business focussed on its options on European stocks and the
Amsterdam exchange had little success with currency options.
Exchanges in Amsterdam, Montreal and Philadelphia allowed for trading in standardised foreign
currency options. Since that time, options have been offered on the Chicago Mercantile Exchange
and The Chicago Board Options Exchange. A currency option is an alternative type of contract
that can be purchased or sold by speculators and firms.
However, the increasing exchange rate volatility by 1982 had made the forex market roughly
receptive to new techniques of exchange rate risk management.
Did u know? Currency options can be used to hedge the foreign exchange risk that results
from commercial transactions and can also be used for speculative purposes.
8.4.1 Advantages of Currency Options
Options are used by buyers just like an insurance policy against movements in rates. Thus, they
are alternatives to using the futures market or to the forward exchange market.
The main advantages of using options are:
The option buyer, at the outset, judges the worst case scenario. Once premium is paid, no
further cash is payable and when the main objective is to limit downside risk, this is a
powerful advantage.
Since there is no obligation to exercise an option, options are ideal for hedging contingent
cash flows which may or may not materialise, such as tenders.
Options provide a flexible hedge offering a range of prices where the option can be
exercised, whereas forward or future markets only deal at the forward prices which exist
at the time the deal is made.
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