Chapter

20

Foreign Currency Futures and Options

QUESTIONS
1. How does a futures contract differ from a forward contract?
Answer: Foreign currency futures contracts, or futures contracts for short, allow individuals
and firms to buy and sell specific amounts of foreign currency at an agreed-upon price
determined on a given future day. Although this sounds very similar to forward contracts,
there are a number of important differences between forward contracts and futures contracts.
The first major difference between foreign currency futures contracts and forward
contracts is that futures contracts are traded on an exchange, whereas forward contracts are
made by banks and their clients. Orders for futures contracts must be placed during the
exchanges trading hours, and pricing occurs in the pit by floor traders or on an electronic
trading platform where demand is matched to supply. In contrast to forward contracts, where
dealers quote bid and ask prices at which they are willing either to buy or sell a foreign
currency, for each party that buys a futures contract, there is a party that sells the contract at
the same price. The price of a futures contract with specific terms changes continuously, as
orders are matched on the floor or by computer.
A second major difference is that futures exchanges standardize the amounts of
currencies that one contract represents. Thus, futures contracts cannot be tailored to a
corporations specific needs as can forward contracts. But the standardized amounts are
relatively small compared to a typical forward contract, and if larger positions are desired,
one merely purchases more contracts. Standardization with small contract sizes makes the
contracts easy to trade, which contributes to market liquidity.
A third major difference involves maturity dates. In the forward market, a client can
request any future maturity date, and active daily trading occurs in contracts with maturities
of 30, 60, 90, 180, or 360 days. The standardization of contracts by the futures exchanges
means that only a few maturity dates are traded. For example, IMM contracts mature on the
third Wednesday of March, June, September, and December. These dates are fixed, and hence
the time to maturity shrinks as trading moves from 1 day to the next, until trading begins in a
new maturity. Typically, only three or four contracts are actively traded at any given time
because longer-term contracts lose liquidity.
The final major difference between forward contracts and futures contracts concerns
credit risk. This issue is perhaps the chief reason for the existence of futures markets. In the
forward market, the two parties to a forward contract must directly assess the credit risk of
their counterparty. Banks are willing to trade with large corporations, hedge funds, and
institutional investors, but they typically dont trade forward contracts with individual
investors or small firms with bad credit risk.
The futures market is very different. In the futures markets, a retail client buys a futures
contract from a futures brokerage firm, which in the United States is typically registered with
the Commodity Futures Trading Commission (CFTC) as a futures commission merchant
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Chapter 20: Foreign Currency Futures and Options

(FCM). Legally, FCMs serve as the principals for the trades of their retail customers.
Consequently, FCMs must meet minimum capital requirements set by the exchanges and
fiduciary requirements set by the CFTC. In addition, if an FCM wants to trade on the IMM, it
must become a clearing member of the CME. In years past, clearing memberships used to be
tradable, and the prices at which they traded were indications of how profitable futures
trading on the exchange was expected to be. In 2000, the CME became a for-profit stock
corporation, and its shares now trade on the NYSE. To obtain trading rights, an FCM must
buy a certain amount of B-shares of CME stock and meet all CME membership
requirements.
When a trade takes place on the exchange, the clearinghouse of the exchange, which is an
agency or a separate corporation of a futures exchange, acts as a buyer to every clearing
member seller and a seller to every clearing member buyer. The clearinghouse imposes
margin requirements and conducts the daily settlement process known as marking to market
that mitigates credit concerns. These margin requirements are then passed on to the
individual customers by the futures brokers.
2. What effects does marking to market have on futures contracts?
Answer: The process of marking to market implies that futures contracts have daily cash
flows associated with them. One can be either long (having bought the contract) or short
(having sold the contract) in the futures market at a particular price. Since both sides are
treated symmetrically, lets assume you are long. You must post funds in a margin account,
and if on subsequent days, the futures price moves in your favor, that is, the foreign currency
futures prices rises as the foreign currency strengthens; funds are placed into your margin
account and are taken out of the margin accounts of those who sold the foreign currency
futures contract. This process continues every day until the maturity date of the contract.
3. What are the differences between foreign currency option contracts and forward
contracts for foreign currency?
Answer: The primary difference between a foreign currency option contract and a forward
contract is that the option contract gives the purchaser of the option, the right, but not the
obligation to transact. If the state of the world in the future is favorable to the purchasers of
the option, they will transact. If the state of the world is unfavorable, the option is worthless.
Forward contracts are completely uncontingent on the state of the world in the future.
4. What are you buying if you purchase a U.S. dollar European put option against the
Mexican peso with a strike price of MXN10.0/$ and a maturity of July? (Assume that it
is May and the spot rate is MXN10.5/$.)
Answer: A European put option gives you the right to sell the underlying asset at the strike
price on the maturity date of the contract. Thus, you are buying the right to sell USD for
MXN at the price of MXN10.0/$ on the maturity date of the contract in July. This option is

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Chapter 20: Foreign Currency Futures and Options

currently said to be out of the money because the strike price is lower than the current
exchange rate.
5. What are you buying if you purchase a Swiss franc American call option against the
U.S. dollar with a strike price of CHF1.30/$ and a maturity of January? (Assume that it
is November and the spot rate is CHF1.35/$.)
Answer: American options can be exercised anytime between the purchase of the option and
the maturity date. Thus, a Swiss franc American call option against the U.S. dollar with a
strike price of CHF1.30/$ and a maturity of January gives the buyer the right, but not the
obligation, to purchase CHF with USD at a price of CHF1.30/$ between November and the
maturity date in January. The option is currently said to be out of the money because the
strike price (expressed in dollars per Swiss franc) is higher than the current exchange rate
[(1/1.30) > (1/1.35)] and you are purchasing CHF.
6. What is the intrinsic value of a foreign currency call option? What is the intrinsic value
of a foreign currency put option?
Answer: The immediate revenue from exercising an option is called the options intrinsic
value. Let K be the strike price, and let S be the current spot rate, both in domestic currency
per unit of foreign currency. Then, the intrinsic value per unit of foreign currency can be
represented as
Call option: max[S K, 0]
Put option: max[K S, 0]
where max denotes the operation that takes the maximum of the two numbers between square
brackets.
7. What does it mean for an American option to be in the money?
Answer: If an American option is in the money, its intrinsic value is positive. For a call
option, this means that the strike price is less than the current market price; while for a put
option, this means that the strike price is greater than the current market price.
8. Why do American option values typically exceed their intrinsic values?
Answer: The time value of an option is the current price or value of the option minus its
intrinsic value:
Time value of an option = Option price Intrinsic value
Options have time value because the stochastic evolution of the underlying asset price
provides possibilities of even better payoffs in the future compared to the intrinsic value. If
this were not the case, the owner of the American option would exercise it.

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9. Suppose you go long in a foreign currency futures contract. Under what circumstances
is your cumulative payoff equal to that of buying the currency forward?
Answer: The payoffs of futures contracts and forward contracts are only essentially the
same because a slight difference in payoffs arises due to the fact that interest is earned on
future profits, or interest must be paid on future losses, in the marking to market process.
Technically, if the path of short-term interest rates could be foreseenthat is, if there were no
random changes in future short-term interest ratesthere would be an arbitrage possibility if
the forward exchange rate were different from the futures price because you would know
how you could invest the profits or borrow to finance your losses. However, future interest
rates are not known with certainty, so forward prices and futures prices can be different, in
theory. In practice, though, the price differentials are minimal, and they appear to be within
the transaction costs of the forward market. Therefore, we argue that futures prices are
essentially the same as forward prices.
10. What is basis risk?
Answer: The basis is the difference between the price of the futures contract at time t, for a
particular maturity in the future, and the spot rate at time t. At the maturity date, the basis is
zero. If the maturity of your foreign currency asset or liability does not match a settlement
date in the futures market, the relationship between the spot exchange rate at the time the
transaction takes place and the futures price of the foreign exchange is somewhat uncertain
(as the basis is not zero). To provide a perfect hedge, the price of the futures contract should
move one-for-one with the spot exchange rate. Then, being long in the foreign currency from
an underlying transaction can be hedged by going short in the corresponding futures contract.
If this is not the case, the hedge is said to suffer basis risk.
11. Your CEO routinely approves changes in the fire insurance policies of your firm to
protect the value of its buildings and manufacturing equipment. Nevertheless, he argues
that the firm should not buy foreign currency options because, he says, We dont
speculate in FX markets! How could you convince him that his positions are mutually
inconsistent?
Answer: Options provide payoffs that are analogous to insurance and can be used in hedging
situations. With fire insurance, you pay the insurance premium, and if there is a fire, the
insurance company compensates you. The realization of the fire is a bad state of the world,
but if the fire does not occur, you needlessly paid for the insurance. If you are receiving
foreign currency, the bad state of the world is that the foreign currency weakens relative to
the domestic currency. To avoid this loss, you can buy a foreign currency put option, which
gives you the right but not the obligation to sell foreign currency at the strike price. If the bad
state of the world occurs, you exercise your put, but if the good state of the world occurs, you
ignore you option and sell the foreign currency which has appreciated in value relative to the
domestic currency. The put option places a floor on your domestic currency revenue, which

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provides a hedge and is not speculation. Of course, ex post you will regret having hedged,
but this is exactly like the insurance situation in which the fire did not occur.
12. Why do options provide insurance against foreign exchange risks in bidding situations?
Why cant you hedge with a forward contract in a bidding situation?
Answer: Lets assume the bidding situation involves the company determining a particular
amount of foreign currency for providing a service or selling some goods. By bidding a fixed
amount of foreign exchange, a company incurs a contingent transaction foreign exchange
risk. If the company wins the bid and the foreign currency weakens relative to the domestic
currency, the domestic currency value of the contractual foreign currency revenue may
already have fallen such that the entire dollar profit could be eliminated before the project
begins. If the firms strategy is to get the contract and then hedge, it could be too late.
Foreign exchange options provide a hedging solution. Because the company ultimately
wants to sell the foreign currency if it wins the bid, the company should hedge by buying a
foreign currency put against the domestic currency. Then, if company wins the contract and
the foreign currency has weakened relative to the domestic currency, the loss of value on the
contract is offset by a gain in the value of the foreign currency put. The company can sell the
foreign currency from the contract at the exercise price, which is higher than the spot market.
If the company does not win the contract, the value of the foreign currency put is the
maximum that the firm can lose. This is exactly like an insurance contract.
If the company sells foreign currency forward, it acquires an uncontingent foreign
currency liability. No matter what happens at maturity, the company will have to sell a
specific amount of foreign currency to the bank. Everything will be fine if the company gets
the contract, but if the company does not get the contract, it will have to buy foreign currency
to fulfill the uncontingent commitment of the forward contract. If the foreign currency has
strengthened, the company will lose money, and the potential loss is essentially unbounded.
13. Suppose that you have a foreign currency receivable (payable). What option strategy
places a floor (ceiling) on your domestic currency revenue (cost)?
Answer: If you have a foreign currency receivable, you eventually want to sell foreign
currency. Purchasing the option that gives you the right to sell (a put option) provides a
hedge that places a floor on your domestic currency revenue. If you have a foreign currency
payable, you eventually want to buy foreign currency. Purchasing the option that gives you
the right to buy (a call option) provides a hedge that places a ceiling on your domestic
currency cost.
14. Describe qualitatively how changing the strike price of the option provides either more
or less expensive insurance.
Answer: Lets consider hedging a foreign currency receivable with a put option. High-quality
insurance in this context means that the floor we create on our domestic currency revenue is
high. The floor is directly related to the strike price of the put option. The higher the strike

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price of the option, the less the foreign currency must depreciate before we can exercise the
option and cut our losses. But, just as insurance that covers more losses is more expensive,
put options with higher strike prices are more expensive. Thus, if the foreign currency
strengthens and you do not need the insurance of the put option, you will have spent more
money on the insurance and will need more appreciation of the foreign currency before you
do better than you could have by locking in a forward contract.
15. Why does an increase in the strike price of an option decrease the value of a call option
and increase the value of a put option?
Answer: We know that holding constant the maturity date of two options implies that the
distribution of possible future exchange rates is the same for the two options. Hence, it
should be apparent that increasing the exercise price of a call option must decrease its value
because doing so removes possible states of the world over which the contract provides
revenue when the strike price is lower. Conversely, increasing the exercise price of a put
option must increase its value because doing so adds possible states of the world over which
the contract provides revenue compared to when the strike price is lower.
16. Why does an increase in the volatility of foreign exchange rates increase the value of
foreign currency options?
Answer: The easiest way to understand how an increase in variance affects option prices is to
place the strike price of a call option at the conditional mean of two probability distributions,
one with a low variance and the other with a high variance. The increase in the variance of
the possible future exchange rate clearly increases the possible range of future exchange
rates. But, because the conditional mean is the same, the probability that the option will
finish in the money is still one-half because one-half of the probability distribution remains
above the strike price. However, if the option does finish in the money, the distribution with
the larger variance yields possibly larger payoffs, and the option will cost more. A
symmetrical argument can be applied to a put option.
17. How does increasing time to maturity affect foreign currency option value?
Answer: Here, it is important to distinguish clearly between American-style and Europeanstyle options. For American options, the effect is unambiguous: Increasing the time to
maturity always increases an options value because it increases the uncertainty of the spot
exchange rate at maturity. When this effect is combined with the fact that the holder of a 6month option can always treat the option as a 3-month option, we clearly see that the
additional 3 months of maturity cannot hurt the payoff to the holder of the option as long as
the holder of the option can exercise it early.
For European options, the situation is not so simple. Although the effect of an increase in
time to maturity is technically ambiguous, in most situations, the effect of the increased
uncertainty of the spot exchange rate at maturity dominates, and option prices increase.

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Nevertheless, this is not always true because it is possible for a European option that is
currently in the money to lose value as time evolves. You would like to be able to exercise the
option to lock in the revenue now, but you cannot do so prior to maturity.
18. What is the payoff on an average-rate pound call option against the dollar?
Answer: The payoff per pound on an average-rate pound call option against the dollar with a
strike price of K($/) is max[0, S ($/) K($/)], where S ($/) defines the average dollarpound exchange rate between the initiation of the contract and the expiration date. To
calculate the average exchange rate, the counterparties to the option contract must agree on a
source for the data and a way of computing the average. They must decide on a time interval
for the observations entering the average, which could be daily, weekly, or monthly, and they
must decide whether the average is an arithmetic or geometric average. At the maturity of an
average-rate option, the seller of the option settles the contract by delivering the dollar value
of the option payoff to the buyer. Because an average of future exchange rates is less volatile
than the future spot rate at maturity, average-rate options are less expensive than standard
European options.
19. Suppose the current spot rate is $1.29/. What is your payoff if you purchase a downand-in put option on the euro with a strike price of $1.31/, a barrier of $1.25/, and a
maturity of 2 months? When would someone want to do this?
Answer: For a down-and-in option, the exchange rate must first cross the barrier to activate
the contract. Then, the buyer of the option has the right to exercise at maturity. So, the payoff
on the option described above is max[0, $1.31/ - S(T,$/)], where S(T,$/) is the exchange
rate at maturity, but only if the exchange rate falls from its current value of $1.29/ to $1.25/
sometime during the 2 months between the initiation of the contract and the maturity date.
Such an option is less expensive than a standard put option. It might therefore be purchased
by someone who is bearish on the euro, believes initial volatility in the market will activate
the option with reasonably high probability, and wants to cut the cost of obtaining a relatively
high payoff, even in the currency strengthens somewhat towards the end of the contract.

PROBLEMS
1. If you sold a Swiss franc futures contract at time t and the exchange rate has evolved as
shown here, what would your cash flows have been?

Day

Futures
Price
$/CHF

0.7335

t+1

0.7391

Change in
Futures
Price

Gain or
Loss

Cumulative
Gain or
Loss

Margin
Account
$2,000.00

0.0056
-$700.00
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$2,000.00

Chapter 20: Foreign Currency Futures and Options

t+2

0.7388

-0.0003

$37.50

-$662.50

$2,037.50

t+3

0.7352

-0.0036

$450.00

-$212.50

$2,487.50

t+4

0.7297

-0.0055

$687.50

$475.00

$3,175.00

Answer: Because you sold the Swiss franc futures contract, you will gain when the Swiss
franc depreciates versus the dollar and you will lose when the Swiss franc strengthens.
On the first day, we assume you established your account with an initial margin of
$2,000, and that you sold your contract at the closing price of $0.7335/CHF. The contract
size is CHF125,000. On the second day, the futures price increases from $0.7335/CHF to
$0.7391/CHF. You consequently lose $0.0056/CHF CHF125,000 = $700, which would
take your margin account to $1,300. Because this is less than the maintenance margin of
$1,400, you would receive a margin call that would require you to bring you margin
account back to $2,000. On the third day, the futures price moves in your favor, and you
gain $0.0003/CHF CHF125,000 = $37.50. You have the option of leaving this extra
money in your margin account or taking it out. We assume that you leave it in. On the
fourth day, the futures price again moves in your favor, and you gain $0.0036/CHF
CHF125,000 = $450. Finally, on the fifth day, the futures price again moves in your
favor, and you gain $0.0055/CHF CHF125,000 = $687.50. The cumulative gain is
$475.00.
2. Given the following information, how much would you have paid on September 16 to
purchase a British pound call option contract with a strike price of 155 and a maturity
of October?
Data for September 16
Calls
Puts
50,000 Australian Dollar Options (cents per unit)
64 Oct

0.48
65 Oct

0.90
67 Oct
0.22

31,250 British Pounds (cents per unit)

152 Dec

4.10
155 Oct
1.50
3.62
155 Nov
2.35

Answer: The correct price on September 16 for a British pound call option with a strike
price of 155 and a maturity of October is 1.50. The units are cents per pound or
$0.0150/. The contract size is 31,250. Therefore, you would have paid
$0.0150
? 31,250 = $468.75

3. Using the data in problem 2, how much would you have paid to purchase a Australian
dollar put option contract with a strike price of 65 and an October maturity?

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Answer: The correct price on September 16 for an Australian dollar put option with a strike
price of 65 and a maturity of October is 0.90. The units are cents per Australian dollar or
$0.0090/AUD. The contract size is AUD50,000. Therefore, you would have paid
$0.0090
? AUD50,000 = $450
AUD
4. Suppose that you buy a 1,000,000 call option against dollars with a strike price of
$1.2750/. Describe this option as the right to sell a specific amount of dollars for euros
at a particular exchange rate of euros per dollar. Explain why this latter option is a
dollar put option against the euro.
Answer: The 1,000,000 call option against dollars with a strike price of $1.2750/ gives the
buyer the right, but not the obligation, to buy 1,000,000 at the strike price of $1.2750/ in
which case the person would pay $1,275,000 for the euros. Clearly, this is the same as an
option to sell $1,275,000 at a strike price of [1 / ($1.2750/)] = 0.784314/$. This latter
option is a $1,275,000 dollar put option against euros with a strike price of 0.784314/$.
5. Assume that today is March 7, and, as the newest hire for Goldman Sachs, you must
advise a client on the costs and benefits of hedging a transaction with options. Your
client (a small U.S. exporting firm) is scheduled to receive a payment of 6,250,000 on
April 20, 44 days in the future. Assume that your client can borrow and lend at a 6%
p.a. U.S. interest rate.
a. Describe the nature of your clients transaction exchange risk.
Answer: Your client is scheduled to receive 6,250,000 in 44 days. If no hedging is done,
and the euro weakens in value relative to the dollar, the client will lose money. The
amount of the loss could be substantial if a major weakening occurs.
b. Use the appropriate American option with an April maturity and a strike price of
129/ to determine the dollar cost today of hedging the transaction with an option
strategy. The cost of the call option is 3.93/, and the cost of the put option is 1.58/
.
Answer: To hedge foreign currency revenue with an option, you must purchase a put
option that gives you the right to sell euros. This puts a floor on your revenue. The cost of
the option would be 1.58/, or
$0.0158
? 6,250,000 = $98,750

c. What is the minimum dollar revenue your client will receive in April? Remember to
take account of the opportunity cost of doing the option hedge.

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Answer: If the exchange rate is less than $1.29/ in April, your client will be able to sell
euros at that value. If the future spot exchange rate is higher, the client will sell euros at
the future spot exchange rate. In either case, if they hedge with the option contract, they
will have less revenue. The future value of $98,750 at 6% for 44 days is

44
6

$98,750 1 +

= $99,474.17
100 360

Thus, the minimum net revenue that the client will have is
$1.29

6,250,000 - $99,474.17 = $7,963,025.83

d. Determine the value of the spot rate ($/) in April that would make your client
indifferent ex post to having done the option transaction or a forward hedge. The
forward rate for delivery on April 20 is $1.30/.
Answer: If the client does the forward hedge, their revenue will be
$1.30
6,250,000 = $8,125,000

If the client does the option hedge and does not have to exercise the option, they will sell
the euros in 42 days, and their revenue will
S(t+42,$/) 6,250,000 - $99,474.17
If this option revenue is to equal the forward revenue, we know
S(t+42,$/) 6,250,000 - $99,474.17 = $8,125,000
Solving this equation gives S(t+42,$/) =

$1.3159
.

6. Assume that today is September 12. You have been asked to help a British client who is
scheduled to pay 1,500,000 on December 12, 91 days in the future. Assume that your
client can borrow and lend pounds at 5% p.a.
a. Describe the nature of your clients transaction exchange risk.
Answer: Your client is scheduled to pay 1,500,000 in 91 days. If no hedging is done, and
the euro strengthens in value relative to the pound, the client will lose money. The
amount of the loss could be substantial if a major strengthening occurs.
b. What is the option cost for a December maturity and a strike price of 0.72/ to
hedge the transaction? The option premiums per 100 euros are 1.70 for calls and
2.40 for puts.
Answer: To hedge foreign currency costs with an option, you must purchase a call option
that gives you the right to buy euros. This puts a ceiling on your costs. The cost of the
option would be 1.70 per 100 euro, or
1.70
1,500,000 = 25,500
100
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c. What is the maximum pound cost your client will experience in December?
Answer: If the exchange rate is greater than 0.72/ in December, your client will be able
to buy euros at that value. If the future spot exchange rate is lower than 0.72/, the client
will buy euros at the future spot exchange rate. In either case, if they hedge with the
option contract, they will have higher costs. The future value of 25,500 at 5% for 91
days is

91
5

25,500 1 +

= 25,817.88
100 365

Thus, the minimum net cost that the client will face is
0.72

1,500,000 + 25,817.88 = 1,105,817.88

d. Determine the value of the spot rate (/) in December that makes your client
indifferent ex post to having done the option transaction or a forward hedge if the
forward rate for delivery on December 11 is 0.70/.
Answer: If the client does the forward hedge, their cost will be
0.70

1,500,000 = 1, 050, 000

If the client does the option hedge and does not have to exercise the option, they will buy
the euros in 91 days, and their cost will be
S(t+89,/) 1,500,000 + 25,817.88
If this option cost is to equal the forward cost, we know
S(t+89,/) 1,500,000 + 25,817.88 = 1, 050, 000
0.6828
.

7. Assume that today is June 11. Your firm is scheduled to pay 500,000 on August 15, 65
days in the future. The current spot is $1.75/, and the 65-day forward rate is $1.73/.
You can borrow and lend dollars at 7% p.a. Suppose you think options are overpriced
because you think the dollar will be in a tight trading range in the near future. You have
been thinking about selling an option as a way to reduce the dollar cost of your pound
payable.
a. If an August pound option with a strike price of 175/ costs 4.5/ per pound for
the call and 4/ for the put, what is the minimum that you will have to pay in
August to eliminate your pound payable? Over what range of future exchange rates
will this price be achieved?
Solving this equation gives S(t+89,/) =

Answer: You need to eventually buy pounds to eliminate your liability of 500,000 due in
65 days. If you think options are too expensive to buy, you can consider the speculative
strategy of selling someone an option that allows them to sell pounds to you. This is a
pound put option. You would take in 4/ for the put, or

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$0.04
500,000 = $20,000

The future value of this amount would be available to offset your costs in 65 days. This
future value is

65
7

$20,000 1 +

= $20,252.78
100 360

As long as the exchange rate is less than or equal to the strike price of $1.75/, your costs
will be
$1.75

? 500,000 - $20,252.78 = $854,747.22

$1.7095
This is
, much less than the forward rate.

b. How much must the pound appreciate before your speculative option strategy ends
up costing you more than the forward rate?
Answer: At the forward rate of $1.73/, you can lock in a dollar cost of
$1.73
? 500,000 = $865,000

The future spot rate that sets the speculative cost to the forward cost is found by equating
the two costs
S(t+63,$/) ? 500,000 - $20,252.78 = $865,000
Solving this equation for the spot rate gives S(t+63,$/) =

$1.7705

8. Upon arriving for work Monday, you observe a violation of putcall parity. In
particular, the synthetic forward price of dollars per yen is above the current forward
rate. How would you capitalize on this information?
Answer: Because the actual forward rate is below the synthetic forward rate, you would want
to contract to buy yen forward and then sell yen at the synthetic forward rate. Such an
arbitrage transaction is called a conversion. You synthetically sell yen forward by buying a
put and selling a call with the same strike price. If the exchange rate in the future is less than
the strike price, the call is worthless and you exercise your put and sell yen at the strike price.
If the exchange rate in the future is greater than the strike price, the put is worthless and the
person to whom you sold the call option exercises the option to buy yen from you at the
strike price. Therefore, you sell yen to them. By doing the two option contracts you have sold
yen forward at the strike price minus the future value of the put you purchased plus the future
value of the call you sold. This synthetic forward price is greater than the actual forward
price, so you make money.
9. Use interest rate parity to demonstrate that you can represent put-call parity as
PC

K
S

1 i ($) 1 i ()

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Chapter 20: Foreign Currency Futures and Options 13

The derivation of put-call parity used the no-arbitrage idea that the forward rate should be equal
to the strike price of the options plus the future value of the cost of a call option minus the future
value of the cost of a put option because each of these sides is a way to purchase foreign
currency, in this case the euro, without any contingencies. Thus,
F K C[1 i ($)] P[1 i ($)]

We first divide by [1 i ($)] to get

F
K

C P
[1 i ($)] [1 i ($)]

From interest rate parity we know that

F S

[1 i ($)]
[1 i ()]

Substituting for F, cancelling [1 i ($)] , and multiplying by -1 gives the desired result.

10. On April 28, 1995, the Paine Webber Group introduced a new type of security on the
NYSE: U.S. dollar increase warrants on the yen. At exercise, each warrant entitled the
holder to an amount of U.S. dollars calculated as
Greater of (i) 0 and (ii) $100 [$100 83.65/$ / Spot rate)]
The spot rate in the formula refers to the yen/dollar rate on any day during the
exercise period, which extended until April 28, 1996. The 1-year forward rate on April
28 was 79.72/$, and the spot rate was 83.65/$.
a. What view on the future yen/dollar rate do investors in this security hold?
Answer: The investor gets the greater of (i) 0 and (ii) $100 [$100 83.65/$ / S(/$)].
If the yen remains unchanged at 83.65/$, the payoff is zero. If the yen strengthens, the
ratio of 83.65/$ / S(/$) > 1, and you would be subtracting an amount greater than $100,
so the payoff would be zero. As the yen weakens, the payoff increases to a maximum of
$100. Thus, the investor must think that the yen is going to weaken.
b. This security was issued at a price of $5.50. To see whether the security is fairly
priced, which option prices would you want to examine?
Answer: While the payoff on the security is non-linear in the yen-dollar exchange rate, it
is linear in the dollar-yen exchange rate. The payoff is zero at exchange rates above 1 /
(83.65/$) = $0.0119546/ and it increases linearly along a forty-five degree angle at
exchange rates below $0.0119546/ until the payoff is $100 at an exchange rate of zero.
This payoff is identical to the payoff on a yen put with a strike price of $0.0119546/ for
an amount of yen equal to $100 83.65/$ = 8,365. Thus, you should examine the price
of a yen put for this amount against dollars to determine if $5.50 is the correct price for
the security.

2012 Pearson Education, Inc.