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Options on Foreign Exchange, Third Edition by David F. Derosa

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CHAPTER 7

Currency Futures Options

A currency futures option exercises into a currency futures contract, whereupon the in-the-money spread between the strike and futures price becomes an immediate credit or debit to accounts having long and short positions.

The practical aspects of trading currency futures options were covered earlier in Chapter 2. In this chapter, I begin with a discussion of the relationship between futures, spot, and forward prices. Next, I cover parity theorems for European and American currency futures options. Afterward, I present models for the valuation of futures options.

CURRENCY FUTURES AND THEIR RELATIONSHIP TO SPOT AND FORWARD EXCHANGE RATES

The Forward Outright

In Chapter 1, I introduced basic nomenclature for foreign exchange transactions. A spot foreign exchange deal is an agreement between two counterparties to promptly exchange sums of currencies. A forward contract is an agreement between two counterparties to exchange sums of currencies on a value day sometime in the future beyond the spot value date.

The exchange rate for a forward deal is called the outright. According to the Interest Rate Parity Theorem, the outright is equal to

Unnumbered Display Equation

where F is the outright, S is the spot exchange rate, Rd is the domestic currency interest, Rf is the foreign currency interest rate, and τ is the time remaining to settlement. All exchange rates are assumed to be ...

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