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A contract giving the buyer the right but not the obligation to buy or sell a given amount of foreign exchange at a fixed price for a specified time period.
An exchange-traded contract calling for future delivery of a standard amount of foreign currency at a fixed time, place, and price.
Requires mandatory delivery
Trading may be conducted only in pre-established multiples of currency units.
A firm wishing to hedge some aspect of its foreign exchange risk is not able to match the contract size with the size of the risk.
Standard Maturity Date
All contracts mature at a pre-established date, being on the third Wednesday of eight specified months.
A firm wishing to use foreign exchange futures to cover exchange risk will not be able to match the contract maturity with the risk maturity.
Collateral and Maintenance Margins
An initial “margin,” at the time a futures contract is purchased is required.
It's an inconvenience to most firms doing international business because it means some of their cash is tied up in a unproductive manner.
Forward contracts made through banks for existing business clients do not normally require an initial margin.
A maintenance margin is also required, meaning that if the value of the contract is marked to market every day and if the existing margin on deposit falls below a mandatory percentage of the contract, additional margin must be deposited.
This constitutes a big nuisance to a business firm, because it must be prepared for a daily outflow of cash that cannot be anticipated.
All futures contracts are with the clearing house of the exchange where they are traded.
Consequently a firm or individual engaged in buying or selling futures contracts need not worry about the credit risk of the opposite party.
Put (on GBP)
A put on pounds sterling is a contract giving the owner (buyer) the right but not the obligation to sell pounds sterling for dollars at the exchange rate stated in the put
Call (on GBP)
A call on pounds sterling is a contract giving the owner (buyer) the right but not the obligation to buy pounds sterling for dollars at the exchange rate stated in the call.
The amount you pay for the option is gone forever, whether or not you exercise the option.
This is the amount paid to the writer of the option, who undertakes the open-ended obligation to deliver pounds to you should you so wish.
If you do not exercise the option, this is the sunk cost of buying options.
If you in fact do exercise the option, your direct profit on the option is reduced by this amount, which has already been paid out.
How can a business firm that has borrowed on a floating-rate basis use a forward rate agreement to reduce interest rate risk?
A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments on a notional principal.
These contracts are settled in cash.
The buyer of an FRA obtains the right to lock in an interest rate for a desired term that begins at a future date.
The contract specifies that the seller of the FRA will pay the buyer the increased interest expense on a nominal sum (the notional principal) of money if interest rates rise above the agreed rate, but the buyer will pay the seller the differential interest expense if interest rates fall below the agreed rate.
Maturities available are typically 1, 3, 6, 9, and 12 months.
Foreign Currency Futures
Alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place, and price.
Similare to commodity futures (cattle, timber, wool)
Selling (Short) a Futures Contract
Locking in the price at which they must sell that currency on that future date.
Foreign Currency Option
A contract that gives the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date).
Option to buy foreign currency
Option to sell foreign currency
Buyer of an option
Seller of an option
Option Price Elements
Exercise (Strike) Price - the exchange rate at which foreign currency can be purchased (call) or sold (put).
Premium - the cost/price/value of the option itself (usually paid in advance, %).
Underlying - actual spot rate in the market.
Gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date.
Can only be exercised on its expiration date.
jQuery1101021176955639384687_1495500254036 The Money
At-the-money (ATM) - option exercise price is the same as the spot price of the underling currency.
In-the-money (ITM) - option is profitable, excluding premium cost, if exercised immediately.
Out-of-the-money (OTM) - option is not profitable, excluding premium cost, if exercised immediately.
Forward Rate Agreement (FRA)
An interbank-traded contract to buy or sell interest rate payments on a notional principal.
Plain Vanilla Swap
An agreement between two parties to exchange fixed-rate for floating-rate financial obligations.