The smaller size of a futures contract and the freedom to liquidate the contract at any time before its maturity in a well-organized futures market differentiate the futures contract from the forward contract. These features of the futures contract attract many users. On the other hand, the limited number of currencies traded, the limited delivery dates, and the rigid contractual amounts of currencies to be delivered are disadvantages of the futures contract to many commercial users. Only by chance will contracts conform exactly to corporate requirements. The contracts are of value mainly to those commercial customers who have a fairly stable and continuous stream of payments or receipts in the traded foreign currencies.
Arbitrage Between the Futures and Forward Markets.
Arbitrageurs play an important role on the CME. They translate CME futures rates into interbank forward rates and, by realizing profit opportunities, keep CME futures rates in line with bank forward rates.
Application Forward-Futures Arbitrage
Suppose the interbank forward bid for June 18 on pounds sterling is $1.8927 at the same time that the price of CME sterling futures for delivery on June 18 is $1.8915. How could the dealer use arbitrage to profit from this situation?
Solution. The dealer would simultaneously buy the June sterling futures contract for $118,218.75 (62,500 X $1.8915) and sell an equivalent amount of sterling forward, worth $118,293.75 (62,500 X $1.8927), for June delivery. Upon settlement, the dealer would earn a profit of $75. Alternatively, if the markets come back together before June 18, the dealer can unwind his position (by simultaneously buying £62,500 forward and selling a futures contract, both for delivery on June 18) and earn the same $75 profit. Although the amount of profit on this transaction is tiny, it becomes $7,500 if 100 futures contracts are traded.
Such arbitrage transactions as described in the “Forward-Futures Arbitrage” application will bid up the futures price and bid down the forward price until approximate equality is restored. The word approximate is used because of a difference between the two contracts. Unlike the forward contract, with which gains or losses are not realized until maturity, marking to market means that day-to-day futures contract gains (or losses) will have to be invested (or borrowed) at uncertain future interest rates. However, a study of actual rates for the British pound, Canadian dollar, Deutsche mark, Swiss franc, and Japanese yen found that forward and futures prices do not differ significantly.1
8.2 Currency Options
Whatever advantages the forward or the futures contract might hold for its purchaser, the two contracts have a common disadvantage: Although they protect the holder against the risk of adverse movements in exchange rates, they also eliminate the possibility of gaining a windfall profit from favorable movements. This disadvantage was apparently one of the considerations that led some commercial banks to offer currency options to their customers. Exchange-traded currency options were first offered in 1983 by the Philadelphia Stock Exchange (PHLX), where they are now traded on the United Currency Options Market (UCOM). Currency options are one of the fastest-growing segments of the global foreign exchange market, accounting for more than 9% of daily trading volume in 2004.
In principle, 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. The seller of the put option or call option must fulfill the contract if the buyer so desires it. Because the option not to buy or sell has value, the buyer must pay the seller of the option some premium for this privilege. As applied to foreign currencies, call options give the customer the right to purchase—and put options give the right to sell—the contracted currencies at the expiration date. Note that because a foreign exchange transaction has two sides, a call (put) option on a foreign currency can be considered a foreign currency put (call) option on the domestic currency. For example, the right to buy euros against dollar payment is equivalent to the right to sell dollars for euro payment. An American option can be exercised at any time up to the expiration date; a European option can be exercised only at maturity.
An option that would be profitable to exercise at the current exchange rate is said to be in-the-money. Conversely, an out-of-the-money option is one that would not be profitable to exercise at the current exchange rate. The price at which the option is exercised is called the exercise price or strike price. An option whose exercise price is the same as the spot exchange rate is termed at-the-money.