Page 142 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 8: Currency Futures and Currency Options

The mechanism of futures trading consists of two points – components of futures trade and Notes
execution of future trade. As the futures market serves the needs of individuals and groups
who may be active or passive traders, risk averse or risk takers, they may be broadly
classified as – price discovery, speculation and hedging
Futures can be applied in various areas – constructing a portfolio, cash contributions/
withdraw portfolio, implementing an active stock market judgment and asset allocation
strategy.

Currency options are one of the fastest growing segments of the global foreign exchange
market. An option is a financial instrument that gives the holder the right – but not the
obligation – to sell (put) or buy (call another financial instrument at a set price and
expiration date. Currency options can be used to hedge the foreign exchange risk that
results from commercial transactions and can also be used for speculative purposes.
Options are of two type – American style and European style. If the option can be exercised
at any time during its lifetime, it is called an American style option but if it can be
exercised only on its expiration data, it is called a European style option.
FX options are traded in two markets – OTC and exchange listed. The OTC is the largest
market where the market participants deal with each other, either directly or through an
OTC broker. The exchange listed markets operate on the floor of the exchange where
brokers gather to reflect their clients’ order with specialists or market makers providing
the prices.
Options can be categorised in two ways. First, according to the type of leakage exhibited
by their underlying assets and second, according to the nature of the underlying asset. The
most challenging aspect of currency options is setting their prices or premium..

8.8 Keywords

All-or-none-order: It allows the commission broker to fill part of an order at a specified price
and remainder at another price.
Continuous Leakage Option Instruments: These are options derived from assets exhibiting a
continuous intervening cash flow.

Discrete Leakage Option Instruments: These are options derived from underlying assets which
exhibit an intervening cash flow that is continuous.
Fill-or-kill Order: It instructs the commission broker to fill an order immediately at a specified
price.
Limit Order: It stipulates to buy or sell at a specific price or better.
On-the-open or on-the-close Order: This represents orders to trade within a few minutes of
operating or closing.
Options: Options are derivative securities that are derived from some underlying assets (stock,
index, currency interest rate, commodity) and their prices depend critically on the spot values of
those assets.
Zero Leakage Option Instruments: These are options written on assets paying no dividends or
interest and having no substantial storage costs.

8.9 Review Questions

1. Define a futures contract. What are the different types of futures contracts? What are the
advantages of using stock index futures?

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