4 December How to Price Cryptocurrency (Bitcoin) Derivatives? December 4, 2017By FX Initiative General Bitcoin, Blockchain, BTC, Continuing Professional Education, CPE, Cryptocurrency, Derivative, Ethereum, Futures, FX Initiative, Hedging, Management, Options, Risk, Trading, Currency 0 Bitcoin (BTC) broke through to a record high of $11,831 over the weekend as volatility in the cryptocurrency continues to rise. Amidst these large and recent price fluctuations, the CME Group (Chicago Mercantile Exchange & Chicago Board of Trade) announced that its new bitcoin futures contract will be available for trading on December 18, 2017. While the valuation of traditional currency and equity derivatives is well established among professionals working in the financial industry, the introduction of the first cryptocurrency bitcoin derivative poses valuation questions as it relates to a new pricing model. Simply put, how are cryptocurrency derivatives priced? Financial engineering is a continuously evolving discipline designed to introduce and test new products, pricing models and hypotheses. Currently, equity futures are typically priced using variables such and the risk free interest rate and dividends, and currency forwards are priced based on the foreign and domestic interest rate differential between the two currencies in the pair. Additionally, equity options are typically priced using the Black–Scholes option pricing model, and currency options are priced using the Garman–Kohlhagen option pricing model. All of these equations take into account variables such as dividends and/or interest rates. However, bitcoin as an asset class does not pay dividends nor is it tied to a specific risk free, domestic or foreign interest rate. As a result, a new or modified version of a derivative pricing model for cryptocurrency that accounts for the unique nature of this new digital asset class will likely be used to value the first bitcoin futures contracts. Many academics and practitioners are sharing their thoughts on the best approach for pricing bitcoin derivatives. A couple of commonly raised questions include: (1) How are dividends removed from the traditional pricing models? and (2) What interest rate(s) should be used? As the financial industry navigates a new frontier with cryptocurrency and blockchain technology, how do you think bitcoin derivatives should be priced? Ready to learn more about currency and derivatives? Click here to take the FX Initiative today! Related Posts Comparing Cryptocurrency to Foreign Currency Cryptocurrencies such as Bitcoin have captured headlines in 2017, and the question of how modern cryptocurrencies compare to traditional foreign currencies is often raised. FX Initiative helps global businesses manage foreign exchange (FX) risk, and this article will explore some of the key differences between cryptocurrency and foreign currency from a corporate foreign exchange risk management perspective. It is clear that cryptocurrencies are still in their infancy, but the debate in the financial community over the future growth of this digital asset class remains open. While many articles have focused on areas such as monetary authorities, regulation, costs, timing, and transparency, this article will offer a unique focus specifically on the areas of acceptance, exchange, utilization, obsolescence, and risk management. Acceptance A small but growing number of brand name companies promote their acceptance of Bitcoin, such as Overstock.com, DISH Network, Expedia, Microsoft, and others. In fact, Coinbase claims that 47,000 businesses integrate Bitcoin with their service. However, companies such as Dell and Fiverr announced their acceptance of Bitcoin in 2014 but have since updated their policies to no longer accept Bitcoin. As ... Due Diligence & Distinguishing FX Derivatives Due diligence is a term that commonly applies to a business investigation, and it contributes significantly to informed decision making by assessing the costs, benefits, and risks of a transaction. As due diligence relates to foreign exchange (FX) risk management, firms can enhance their strategic decision making process by assessing the costs, benefits, and risks associated with currency derivatives, and recognizing their differences and similarities when hedging foreign currency transactions. At the highest level, currency derivatives are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. FX risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using FX derivatives to achieve FX objectives. The first part of the FX risk management decision making process is determining a firm’s FX hedging objectives and strategy for achieving those objectives. The two most common FX risk management hedging objectives are (1) minimizing foreign exchange gains and losses in earnings and (2) preserving cash flows. The most common currency derivatives used in practice are (1) forward contracts, ... How to Compare Currency Derivatives & Credit Considerations Foreign exchange risk management involves the use of currency derivatives, which are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. In order to use currency derivatives to achieve foreign exchange risk management objectives, companies must be able to deal or trade with a credit worthy counterparty such as a bank or financial institution. Counterparty credit risk is the risk that the counterparty to a contract does not perform, and is involved in any banking activity, including trading currency derivatives. Therefore, both parties in the transaction need to consider the financial condition of their counterparty by quantifying their creditworthiness. It can be helpful to compare key credit considerations between the three most common currency derivatives, which include forward contracts, vanilla options, and zero cost collars. Forward contracts involve the exchange of two currencies at an agreed upon rate on the date of the contract for settlement on a date more than two business days in the future. A forward contract will almost always finish in either an asset or liability position ... Practice Pricing FX Derivatives Would you like to practice pricing FX derivatives? The FX Derivative Speculator is a risk modeling tool you can use to compare and contrast pricing variables and payoff profiles of FX derivatives to analyze the economic impact on cash flows and the financial reporting implications under virtually any FX rate scenario. This customizable and interactive web application quickly and easily demonstrates how higher and lower interest rates determine the forward rate, how the upfront premium of an option is priced and accounted for, and how a zero cost collar blends characteristics of forwards and options. Get started with our foreign exchange risk management training, which provides 24/7 365 access to our complete suite of foreign exchange (FX) continuing professional education (CPE), examples and events at FXCPE.com. Start Training > Download the PDF Discover the Different Types of FX Derivatives Do you want to discover the different types of FX derivatives in detail? FX Initiative’s FX Spot & Derivatives course will help you distinguish the different type of FX derivatives firms employ to effectively hedge FX risk. This program provides a comparative analysis of FX derivatives with simulated examples to demonstrate the instruments your firm can use. Get started with our foreign exchange risk management training, which provides 24/7 365 access to our complete suite of foreign exchange (FX) continuing professional education (CPE), examples and events at FXCPE.com. Start Training > Download the PDF There’s No Free Lunch with FX Derivatives Milton Friedman, the American economist who received the 1976 Nobel Memorial Prize in Economic Sciences, wrote a book titled "There's No Such Thing as a Free Lunch" and that saying is particularly applicable for understanding currency derivatives. When selecting a foreign exchange hedge instrument, firms can benefit from recognizing the differences and similarities of common derivatives such as a forward contracts, vanilla options, or zero cost collar option combinations. The FX Spot & Derivatives course explores the concepts of forward contracts, put and call options, and zero cost collars and examines their pricing variables and payoff profiles. Many firms seek protection from unfavorable changes in exchange rates while also seeking to retain the ability to participate in favorable rate movements. This 1 hour program will reveal the mechanics of the most common currency derivatives, and underscore how “there is no such thing as a free lunch” with FX derivatives. Want full access? Click to subscribe today! If you are interested in learning more about foreign exchange deritatives and how they are used in practice, sign up for our Foreign Exchange Risk Management Training today ... Comments are closed.