Trading Case XR2


Case Objectives

To understand using options and futures to manage currency risk; to understand options trading strategies in an environment in which exchange rate crises exist.  Finally, to gain experience working with a derivative trading support system. 


Key Concepts

Currency option and futures pricing; option hedge parameters; implied volatility shifts.


Case description

Currency markets can experience very volatile periods.  For example, in the 1992 European currency crisis the implied volatility for sterling/dollars and dm/dollars jumped from the 11-12% range in August 1992 to in excess of 20% by October 1992 and then fell back sharply to above historic levels.


A study by a US consulting firm (Barra) found that exchange rate movements affected fixed income and equity assets in a portfolio very differently.  Approximately 80% of the volatility of fixed income returns and approximately 30% of the volatility of equity returns was attributed to exchange rate fluctuations.  It is not surprising, therefore, that the demand for currency hedging is increasing.


In this trading case you will face the problem of managing exchange rate risk in a currency crisis.  That is, during each trading trial a currency crisis will occur at some point in time which is marked by a sharp increase in volatility.  Although, the timing and the duration of the crisis is random, prices in the options markets will only provide signals that volatility is expected to increase near the time of the realized increase. 


You will compete against other traders in the FTS markets by earning grade cash with respect to a conversion scheme that is designed to both reward you for seeking out higher returns but penalize you for dropping below an acceptable floor.


The operational details of this trading case are the same as for XR1.  The major difference is that a significant shift in volatility will occur at some time during the trading year (trial).


Trading Screen

Each trader's screen will monitor eight markets: the exchange rate, a risk-free bond (strip) with 104 weeks remaining to maturity at the beginning of the period, European call and put options on the exchange for two different strike prices with a remaining life of 52 weeks, an exchange rate future contract, and a cash money market.


Definition of A Trading Trial

One trial in this case is almost 12 months, but time is condensed so that two weeks is equal to “n” seconds.  That is, throughout the trial trading is continuous but prices will change in discrete time, two week steps every “n” seconds of FTS time.   That is, in calendar time the markets are open for FTS traders on the first trading day of every two weeks.

Note:  In the default form of the case “n” seconds equals 20.  

The following table describes price changes in this market:


Calendar Time




Day 1, Week 1

Time 0-20 seconds

Day 1, Week 3

Time 21-40 seconds

Day 1, Week 5

Time 41-60 seconds




New prices are realized for each trading Day (20 second interval).  Prices reflect the underlying difference in calendar time.  That is, the Treasury Strip appreciates toward its face value over time, and option prices reflect the time left to maturity etc.


At the end of the year ( = one trading trial), your currency position is marked-to-market at the prevailing rate.


Market Environment

The first market is the exchange rate.  This is the value of 500 units of the basket of currencies (bfx) in units of $US.  Analyst research has indicated that the statistical process that approximately describes the behavior of this exchange rate is a geometric Wiener process with the following properties:


Projected Normal Volatility of return () is around


14%-16% per annum

Spot Index Value (Bid/Ask)

Near 300

Projected Drift ()

0.0% per annum

Unit of Time

2 week (20 seconds)

Eurodollar rate US


Euromark rate



The projected volatility is a little above historical averages for volatility but well below the heights reached in the European currency crisis in 1992.


Securities And Trading Restrictions

Financial Markets

Spot x-rate (500 bfx) in $US (S)

US Treasury Strip (maturity 104 weeks)

52 week call on spot x-rate, Strike 290

52 week Put on spot x-rate, Strike 290

52 week Call on spot x-rate, Strike 310

52 week Put on spot x-rate, Strike 310

X-rate Future (500 bfx / 52 weeks)

Money market (3% p.a.)


The currency crisis is not interest rate related, so you can assume that the interest rates remain constant.


Trading Objective

Your trading objective is to earn as much grade cash as possible subject to the constraints imposed by your firm upon your trading activities.


Earning Grade Cash

Securities are exchanged using market cash in a trading period that lasts for 52 weeks. Each 52 weeks is referred to as one trading trial.  Multiple independent trials will be conducted.


That is, at the start of a trial your initial endowment is either Type A or Type B, and an independent exchange rate path (starting from the spot lot price of around 300).


If at the end of any trial you have a closing balance of $4,500,000 market cash you will earn $20 grade cash.  If you have a closing balance of market cash that is lower than $4,500,00 you will earn $0 grade cash.  Any amount of market cash that is greater than $4,500,000 and less than or equal to $100,000,000 earns grade cash as follows:



Above $100,000,000 market cash earns the maximum of $402 grade cash for one trial.


Trading is conducted over a number of independent trials and a record of your cumulative grade cash is maintained.


Linking to the Trading Support Spreadsheet for Trading Case XR2


Download the trading support spreadsheet for XR2 (just below the ftsTrader link) from the Virtual Classroom page and open it in Excel. 


Note:  Read carefully the appropriate Excel settings from the Virtual Classroom section where you download the XR2 support spreadsheet from.


Launch the FTS Trader and link to the market.  In FTS Trader click on the File menu and select Excel Link from the sub menu items.  The following screen will pop up.  Select the spreadsheet titled XR2TradSupport and be sure to select Sheet 1 as the Market Data Sheet and Sheet 2 as the Trading History Sheet as depicted below:



Click OK and the spreadsheet is automatically linked to the market.  By giving focus to the spreadsheet (i.e., resize so it is on the same screen as your trading window), you can see your position greeks update in real time.  The spreadsheet support is illustrated below:



Corresponding Trading Screen in the FTS Trader


© 2003 OS Financial Trading System



Trading Tips for Trading XR2


In trading case XR2 you are a short term “news trader.”  You have information that lets you form a “market view” about the short term price behavior of the underlying exchange rate.  In XR2 the price of the underlying exchange follows the geometric Brownian motion process assumed by Black and Scholes with one important difference.  During the trading period at least one significant economic news event will occur that will result in the price of the exchange rate taking a jump.  However, you do not know when the jump will take place or it’s magnitude and direction.  In addition, there may be more than one significant jump (but there will be at least one).  Unlike the real world you do not face any liquidity or capital constraints.


You have an initial position in an option that you cannot trade, but you can trade the remaining derivatives (option and futures).  As a result, your task is to manage your trading strategy so that it makes money if your view of the market is correct.  At any time if you want to lock in your trading gains you can also manage the delta of your position.  By linking to the XR2 support spreadsheet (you can download this from the Virtual Classroom page immediately below where you download the FTS Trader from).


Why Delta?


Delta is a measure of the dollar sensitivity of your position to changes in the underlying (i.e., the exchange rate).  Formally, the delta of a derivative security is the partial derivative (i.e., calculus) of the derivative security’s price w.r.t. a change in the underlying asset price.  The delta of each security and your position’s delta are provided in the support spreadsheet in real time.  


Excel Note for FTS Trader:  If Excel is set to Automatic Calculate (Tools, Options, Calculations, Automatic) and you link FTS Trader to this spreadsheet, it will automatically recalculate your position delta whenever the exchange rate changes in XR2. 


By trading the options and futures you can manage your position delta to be approximately zero, positive or negative.  For the case of a zero position delta your position’s value will be relatively insensitive to shifts in the underlying exchange rate.  If you assume a large positive position delta your position will be very sensitive to shifts in the price of the underlying (with increasing sensitivity the larger your position delta is).  That is, if the underlying exchange rate increases so does your position’s value and if the underlying exchange rate decreases your position value will decline.  Finally, if you assume a large negative position delta then the value of your position responds in the opposite way to the change in the exchange rate.  That is, if the exchange rate increases your position’s value decreases and vice versa.


Finer points:  Your position gamma is a measure of how sensitivity your position delta is to changes in the underlying.  Formally, gamma is the partial derivative (in calculus) of the derivative security’s delta w.r.t. the underlying asset price (i.e., the second partial derivative w.r.t. the underlying asset price).  In the field, suppose a dealer is hedging the exchange rate risk by maintaining an approximate delta neutral exposure (i.e., position delta equals 0).  If a dealer maintains a gamma sensitive (i.e., large position gamma) position they must adjust delta frequently and by larger amounts to maintain a zero position delta.  If a dealer maintains a gamma insensitive position (i.e., approximately zero position gamma) then this reduces the frequency and size of delta adjustments that need to be made to maintain a zero position delta.  In practice by reducing the size and frequency of having to adjust your position’s delta results in a source of significant transaction cost savings.


Finally, your position Vega is a measure of how sensitive your position is to volatility.


Inferring Information from Implied Volatility Estimates:  You should monitor the implied volatility in your spreadsheet because prior to a crisis you will observe in this trading case that implied volatility makes a significant initial jump.  After the first jump it will then jump again and so you should think about how you can adjust your trading strategies to exploit this information.


© 2003 OS Financial Trading System