Chapter 13 - Currency Derivatives: Futures, Options and Swaps

Chapter Introduction
Since the early 1970s there has been an enormous growth in the use of what is known as derivative instruments. In this chapter we look at three types of derivative contracts: futures, options and swaps. The aim of the chapter is to introduce the reader to the basic features. In particular, we emphasize how the contracts can be used for both speculative and hedging purposes and the advantages and disadvantages of the various contracts. We also look at basic formulae governing the appropriate pricing of futures and options contracts.

Standardized financial futures and options contracts are traded on organized exchanges. They were first traded on the Chicago Board Options Exchange (CBOE) in the early 1970s, and in 1982 London opened the London International Financial Futures Exchange (LIFFE) which in 2001 was merged with the Amsterdam, Paris and Belgium Exchanges to create Euronext.LIFFE. Since then Euronext has also merged with the Lisbon Stock Exchange. A significant amount of trading in foreign currency options is done outside of the major exchanges in what is known as the ‘Over-the- Counter’ market (OTC) in which banks and other financial institutions design contracts tailor-made to meet the specific needs of their corporate clients. The swaps market is an over-the-counter (OTC) market with swaps between two parties being arranged on tailor-made basis.