9.3 Derivatives markets

between the date of the coupon prior to the delivery of the bond and the delivery

date. These two modications mean that the buyer of the contract must pay for

the bond delivered to him the nal settlement price for the notional bond plus any

unpaid interest accrued on the bond. Of the bonds eligible for delivery, the seller

always chooses the bond that is cheapest for him to deliver – the cheapest to deliver

(CTD) bond. Delivery may take place on any day of the delivery month, although

in practice it is always on either the rst or the last day of the month. If the current

yield on the bond that is to be delivered is greater than the money market interest

rate, the seller will retain the bond until the last day of the month before delivering

it. On the other hand, if money market interest rates are higher, he will deliver the

bond on the rst day of the month.

9.3.2Options

An option gives the right to buy or sell a given amount of a nancial instrument

or commodity at an agreed price (known as the exercise priceor strike price) within

a specied time, but does not oblige investors to do so. Just as with futures, options

contracts are drawn up between two counterparties, the purchaser and the writer

(seller) of the option, and are registered with and traded through a nancial futures

exchange. Options contracts are offered both on cash securities (short- and long-term

interest rates, exchange rates, equities of individual companies, and stock exchange

indices) and on futures contracts. For options on cash securities (premium paid options),

the buyer pays the full price or premium of the option at the time of purchase. For

options on futures contracts (premium margined options), buyers and sellers are margined

and marked to market in the same way as with futures themselves.

Call options:Options that give the right to buy a given amount of a nancial instrument

or commodity at an agreed price within a specied time but, like all options, do not

oblige investors to do so.

Banks construct non-tradable, custom-made over-the-counter (OTC) options for

their customers. These make up a high proportion of the total value of options sold.

The average daily turnover in the UK for all OTC currency and interest rate derivat-

ives in April 2004 was $643 billion, comfortably more than double the gure of $275

billion recorded three years earlier. Of this total, 12 per cent were foreign currency

options and swaps and 15 per cent interest rate options (up from 5 per cent since

2001). The remaining seventy-three per cent were interest rate swaps (discussed in

Chapter 10) and forward rate agreements (FRAs), with interest rate swaps remain-

ing the biggest single category (Williams, 2004). Interest rates clearly remained the

dominant underlying asset.

The buyer of a call option acquires the right to buy the specied instrument.

For example, an investor who thinks that sterling is likely to rise in value against

the US dollar could buy a £/$ option, giving the right to buy sterling at a specied

price, say £1 $1.80. The holder of the option then has the right to acquire sterling

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

at that price at any time during the life of the option and is thus in a position to

benet from a rise in the spot price of sterling. If the spot exchange rate were to rise

to £1 $1.90, the option holder could acquire sterling at $1.80 under the terms

of the option and sell it in the spot market at $1.90. The buyer of a call option thus

assumes a long position in the underlying product (in this case £). As the price of

the underlying product rises, so too will the prot that can be made from exercising

the option. Consequently, the premium that must be paid to acquire the option

rises and this allows the holder of a call option to realise her prot by selling the

option on rather than by exercising it. If the option did not rise as the price of the

underlying product rose, there would be a protable arbitrage opportunity.

Put options:Options that give the right to sell a given amount of a nancial instrument

or commodity at an agreed price within a specied time, but that do not oblige investors

to do so.

The buyer of a put option acquires the right to sell and thus assumes a short

position in the specied product. That is, the buyer of a put option stands to gain

from a fall in the price of the underlying product. Therefore, someone who buys

a put option at £1 $1.80 hopes that the value of sterling falls below that level.

He would be able to buy sterling in the spot forex market at, say, £1 $1.70 and

then exercise the option in order to sell the sterling at $1.80. In this case, as sterling

falls, the protability of a put option in sterling rises and the premium that other

investors are prepared to pay in order to acquire such an option increases. As before,

the holder of the put option can realise his prot by selling the option on rather

than by exercising it.

Just as in the futures market, the holder of an option sells it (closes out her market

position) by entering into a reversing contract. That is, in the rst case above in which

we assumed that sterling was rising in value, a holder of a call option in sterling ‘sells’

the option by writing (that is, selling) a call option on the same productfor the same

expiry date, in effect cancelling his right to buy sterling. However, the increase in the

price of the sterling will have meant that the premium received for the sale of the call

option will be greater than the premium paid to purchase the initial call option.

The example of a call option given above states that the option can be exercised

at any time during its life up till (and including) the expiry date. Such an option

is known as an American option. There exist also European options, which give

holders the right to exercise the option on the expiry date only. Most traded options

are American options.

As with futures contracts, few options produce a delivery of the underlying

product because protable market positions are generally closed out before expiry

while unprotable options are left to lapse, with the buyer losing only the premium.

Therefore, the prot for most buyers of options is given by the change in the option

premium between its purchase and sale. Options, then, like futures, give traders the

opportunity to speculate on the likely direction of a market without actually trading

in that market.

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