SPECIFIC APPLICATION AREAS

7.6 SPECIFIC APPLICATION AREAS

Foreign exchange is a fertile ground for the application of financial products, their pricing and their analyses. Basic transactions (through the interbank or the wholesale market) on spot, futures, forwards and swap and other prod- ucts are applied extensively. FX trading is assuming greater importance. The Philadelphia Exchange trades, for example, options on the British pound, German mark, Japanese yen, Swiss franc and the Canadian dollar. The most heavily traded contracts are the Deutschemark and Japanese yen American-style

OPTIONS AND PRACTICE

options. The strike price for each foreign currency option is the US dollar price of

a unit of foreign exchange. The expiration dates correspond to the delivery dates in futures. Specifically, the expiration dates correspond to the Saturday before the third Wednesday of the contract month. Contract months are March, June, September and December plus the two near-term contracts. The daily volume of contracts traded on the Philadelphia exchange has steadily increased to over

40 000 contracts per day.

Strike price Premium Currency

Contract

quotations Mark

size

intervals

1.0 Cents Sterling

2.5 Cents Swiss franc

1.0 Cents Yen

6 250 000 0.01 Hundredth cent

Consider the British pound for example. Each contract is for 31 250 British pounds. Newspapers report the closing spot price, in cents per pound sterling. The strike prices are reported in cents per pounds, at 2.5-cent intervals. The call and put premiums are also in cents per pound. Consider the theoretical price of a European call option on the British pound that trades at the Philadelphia Exchange. The time to expiration is 6 months. The spot is $1.60 per pound. An at-the-money call is to be valued where the exchange rate volatility is 10 % per year. The domestic interest rate and the foreign interest rate are both equal to

8 %. Using the theoretical price of the European call option given below, we find the option price to be $0.0433. The equations for this problem are similar to the Black–Scholes model, as we saw earlier and in the previous chapter, and are summarized below.

Price of a European call option on foreign exchange

(0) = G(0)N (d 1 )−Ke

−r T

N (d 2 ); d 1 = √ ln [G(0)/K ] σ T

−r F with σ the volatility of foreign exchange and G(0) = S(0) e T where r F is the risk-free rate in the foreign currency.

FX swap contracts are made by drafting purchase–repurchase agreements by selling simultaneously one currency (say DM) in the spot and the forward market. Swap contracts are immensely popular contracts and will be treated in the next chapter in the context of interest-rate-related contracts.

In practice, financial products can be tailored to sources of risks and can respond to specific business, industrial or other needs. For example, financial products that meet firms’ risks related to climatic risks and energy supplies. Climatic factors in

197 particular account for a substantial part of insurance firms’ costs. The December

OPTION MISSES

1999 storm that hit France may have cost 44.5 billion francs! – hitting hard both the French insurance companies and reinsurance firms throughout Europe. Cli- matic risks also have an important effect on the US economy, accounting for approximately 20 % of GNP according to the Department of Energy. There are in fact few sectors that are immune to weather effects and thereby the importance of all risk-management activities related to meteorological forecasting, robust construction, tourism, fashion etc. Energy needs in particular, are determined by the intensity of summer heat and winter cold, generating fluctuations in demand and supply for energy sources. An expanding climatic volatility has only added to the management of these risks. For this reason, firms such as ENRON (now defunct), Koch, Aquila and Southern Energy have focused attention on the use of financial energy-related products that can protect sources of supplies and meet demands. As a result, since 1997, there have been energy products on the CME and, since 2000, on London’s LIFFE, providing financial services to energy in- vestors, speculators and firms. The underlying sources of risk of energy firms (as well as many supply contract) span:

(a) (b)

(c) To manage these risks, derivative products on both the price and the supply

contract are used. These contracts, over multiple sources of risks, are difficult to assess and are currently the subject of extensive research and applications.