In earlier posts we covered futures markets. One of the important innovations of futures markets is options on futures. These contracts originated in the United States as a result of a regulatory structure that separated exchange-listed options and futures markets. The former are regulated by the Securities and Exchange Commission, and the latter are regulated by the Commodity Futures Trading Commission (CFTC). SEC regulations forbid the trading of options side by side with their underlying instruments. Options on stocks trade on one exchange, and the underlying trades on another or on Nasdaq.
The futures exchanges got the idea that they could offer options in which the underlying is a futures contract; no such prohibitions for side-by-side trading existed under CFTC rules. As a result, the futures exchanges were able to add an attractive instrument to their product lines. The side-by-side trading of the option and its underlying futures made for excellent arbitrage linkages between these instruments. Moreover, some of the options on futures are designed to expire on the same day the underlying futures expires. Thus, the options on the futures are effectively options on the spot asset that underlies the futures.
A call option on a futures gives the holder the right to enter into a long futures contract at a fixed futures price. A put option on a futures gives the holder the right to enter into a short futures contract at a fixed futures price. The fixed futures price is, of course, the exercise price. Consider an option on the Eurodollar futures contract trading at the Chicago Mercantile Exchange. On 13 June of a particular year, an option expiring on 13 July was based on the July Eurodollar futures contract. That futures contract expires on 16 July, a few days after the option expires.” The call option with exercise price of 95.75 had a price of $4.60. The underlying futures price was 96.21. Recall that this price is the IMM index value, which means that the price is based on a discount rate of 100 – 96.21 = 3.79. The contract size is $1 million. The buyer of this call option on a futures would pay 0.046($1,000,000) = $46,000
and would obtain the right to buy the July futures contract at a price of 95.75. Thus, at that time, the option was in the money by 96.21 – 95.75 = 0.46 per $100 face value. Suppose that when the option expires, the futures price is 96.00. Then the holder of the call would exercise it and obtain a long futures position at a price of 95.75. The price of the underlying futures is 96.00, so the margin account is immediately marked to market with a credit of 0.25 or $625.” The party on the short side of the contract is immediately set up with a short futures contract at the price of 95.75. That party will be charged the $625 gain that the long made. If the option is a put, exercise of it establishes a short position. The exchange assigns the put writer a long futures position.

As we noted in earlier posts, the currency forward market is quite large. The same is true for the currency options market. A currency option allows the holder to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate, expressed as an exchange rate, Many companies, knowing that they will need to convert a currency X at a future date into a currency Y, will buy a call option on currency Y specified in terms of currency X. For example, say that a U.S. company will be needing €50 million for an expansion project in three months. Thus, it will be buying euros and is exposed to the risk of the euro rising against the dollar. Even though it has that concern, it would also like to benefit if the euro weakens against the dollar. Thus, it might buy a call option on the euro. Let us say it specifies an exercise rate of $0.90. So it pays cash up front for the right to buy €50 million at a rate of $0.90 per euro. If the option expires with the euro above $0.90, it can buy euros at $0.90 and avoid any additional cost over $0.90. If the option expires with the euro below $0.90, it does not exercise the option and buys euros at the market rate.
Note closely these two cases:
Eum expires above $0.90
Company buys €50 million at $0.90
Eum expires at or below $0.90
Company buys €50 million at the market rate
These outcomes can also be viewed in the following manner:
Dollar expires below €1.1111, that is, €1 > $0.90
Company sells $45 million (€50 million X $0.90) at € 1.1 1 1 1, equivalent to buying €50 million
Dollar expires above €1.1
11 1, that is, €1 < $0.90
Company sells sufficient dollars to buy €50 million at the market rate This transaction looks more like a put in which the underlying is the dollar and the exer- cise rate is expressed as €1.1 11
1. Thus, the call on the euro can be viewed as a put on the dollar. Specifically, a call to buy €50 million at an exercise price of $0.90 is also a put to sell €50 million X $0.90 = $45 million at an exercise price of 1/$0.90, or €1.11 1 1.
Most foreign currency options activity occurs on the customized over-the-counter markets. Some exchange-listed currency options trade on a few exchanges, but activity is fairly low,