FX & FX DERIVATIVE

FX Derivatives
1. Carry Trade Return …………………………………… P. 2
2. Volatility …………………………………… P. 7
3. Correlation …………………………………… P. 21
4. Option …………………………………… P. 32
5. Futures …………………………………… P. 42
6. Forward …………………………………… P. 46
7. NDF …………………………………… P. 57
8. FX swap …………………………………… P. 61
9. Cross currency basis swap …………………………………… P. 65
10. Cross currency swap …………………………………… P. 68
11. NDS …………………………………… P. 71
12. NDIRS …………………………………… P. 75
13. Power Reversal Dual Currency Note …………………………………… P. 78
14. Dual Currency Deposit …………………………………… P. 79
15. Straddle …………………………………… P. 82
16. Strangle …………………………………… P. 83
17. Risk Reversal …………………………………… P. 85
Collar P. 86
Enhanced Collar P. 88
18. Participating Forward …………………………………… P. 91
Forward Extra P. 93
19. Call / Put Spread …………………………………… P. 96
20. Calendar / Horizontal Spread …………………………………… P. 99
21. Diagonal Spread …………………………………… P. 101
22. Seagull …………………………………… P. 103
23. Butterfly …………………………………… P. 105
24. Condor …………………………………… P. 108
25. Knock-in & Knock-out …………………………………… P. 111
Knock-in Knock-out …………………………………… P. 112
26. Digital …………………………………… P. 114
27. Average Option …………………………………… P. 115
28. Fader …………………………………… P. 116
29. Range Accrual …………………………………… P. 118
Digital Range Accrual P. 118
30. FX Accumulator …………………………………… P. 120
Compound …………………………………… P. 122
31. Risk Management …………………………………… P. 122

Page 1
 1. Carry Trade

Carry trade involves borrowing a low-yielding currency to purchase a higher yield currency or
asset. This trade is executed by borrowing or shorting currencies with low levels of interest. Since
the demand and supply of a currency are affected by many factors, such as interest rate, Trade
deficit, money supply, inflation, government policy, … etc. The better the economy of a country
performs, the higher value of its currency is.

Before the financial Crisis in 2008, investors like to borrow low-cost funding, such as USD and
JPY, in order to get capital to invest into Brazil and other emerging markets. However, rising
unemployment and declining stock markets are causing traders to reduce bets on higher-risk
currencies such as Brazilian real BRL and Australian dollar AUD. As a result, Japanese Yen JPY
typically benefit in times of turmoil because traders need to buy back JPY to repay low-cost loans.

After the crisis, market tends to emphasize on fundamental valuations in times of high volatility
and uncertainty. As trade imbalances mend against a backdrop of global recession, currencies of
countries with trade surpluses should tend to increase in value, as foreigners need to buy currency
to make payment, especially in China. Whereas, the US has been suffering trade deficit for many
years and accumulating huge current account deficit, causing USD to depreciate.

Figure 1. US Deficit and USD

A strategy of buying the currencies of the nations with the 5 largest trade surpluses relative to their
GDP and selling those of the countries with the 4 largest deficits returned more than 6% by the end
of February 2009. Type {ALLQ EHCA<GO>} to display the most –recent data on current account
balances of nation as a percentage of GDP.

Page 2
Figure 2. FXCT<GO>, the FX Carry-Trade Index function to track the performance of a basket
of currencies with surplus and deficit in current accounts

FXCT in figures 2 shows the carry trade performance with Long currency basket of countries with
large trade surplus, such as CNY, HKD, SGD, CHF and NOK, and a Short currency basket of
countries with huge trade deficit, such as USD, GBP, ZAR and ISK. A strategy of buying
currencies with surpluses will gain more credibility as interest rates narrow.

Carry return calculation

Carry trade return consists of the spot return of Buy/Sell a currency pair and interest return of
Borrowing/Lending the currency pair.

Carry Return = [(1+Spot Return) × (1+Interest Return)-1] ×100%.

Interest return is not the interest rate itself. Interest return is the return gained from collecting
interests on a currency. It only uses the accumulated interest and ignores the spot movement. To
calculate the interest returns, first calculate an "Interest Index", an index that has value changes
solely due to interest fluctuations, then calculate the return of that index so as to calculate the
interest return.

Page 3
Here is in details the procedure for total return calculation of EUR/USD from 1/1/99 to 01/08/99:

Figure 3. WCRS<GO> World Currency Ranker in Carry Return

To calculate Carry trade return of Long EUR / Short USD from 01/01/1999 to 01/08/1999 :

First of all, we need to get the Spot return:

= (Plast 01/08/99 – Pstart 01/01/99)/ Pstart 01/01/99 × 100
= (1.1585 – 1.18 )/ 1.18 × 100%
= - 1.8220%

EUR/USD Spot Spot

Date PX_LAST Return
1/1/2009 1.18
1/4/1999 1.1837
1/5/1999 1.1761
1/6/1999 1.1628
1/7/1999 1.1712
1/8/1999 1.1585 -1.8220

Then we need to calculate the Interest return:

In {WCRS<GO>}, 3 month EUR deposit and 3 month USD deposit from source Bloomberg
Derive BDSR is used to calculate interest return. 260 days is the assumed number of days in a
year.

EUDRC BDSR Curncy USDRC BDSR Curncy EUDRC/(260x100) USDRC/(260x100)

Date 3M depo rate Date 3M depo rate
1/1/1999 3.215 1/1/1999 4.94 0.000123654 0.00019
1/4/1999 3.195 1/4/1999 4.94 0.000122885 0.00019
1/5/1999 3.175 1/5/1999 4.94 0.000122115 0.00019
1/6/1999 3.1537 1/6/1999 4.94 0.000121296 0.00019
1/7/1999 3.175 1/7/1999 4.94 0.000122115 0.00019
1/8/1999 3.175 1/8/1999 4.88 0.000122115 0.000187692

Page 4
Then, the different between the EUDRC/(260 ×100) and USDRC(260 ×100) is need to generate
an interest rate index for borrowing USD and investing into EUR.

Interest rate IndexT = Index(T-1) ×[1+Spread T].

Spread Formula Index Interest

Date return
1/1/1999 -0.00006634615 100.00
1/4/1999 -0.00006711538 100x(1+ -0.00006711538) = 99.9933
1/5/1999 -0.00006788462 99.99329x(1+ -0.00006788462) = 99.9865
1/6/1999 -0.00006870385 99.9865x(1+ -0.00006870385) = 99.9796
1/7/1999 -0.00006788462 99.97963x(1+ -0.00006788462) = 99.9728
1/8/1999 -0.00006557692 99.97284x(1+ -0.00006557692) = 99.9663 -0.0337

The calculation of interest returns 3 month borrowing USD and investing EUR :
= [ ( IR(endDate 01/08/09) - IR(startDate 01/01/09) ) / IR(startDate 01/01/09) ] × 100%
= [ (99.9663 – 100) / 100 ] × 100%
= - 0.0337%

Finally to calculate the Carry Trade Return :

Carry trade return is the multiple of Spot return and Interest return, as Carry Trade traders are
exploring into the exchange rate risk and interest cost.

Carry Trade Return = {[(1+Spot return/100)×(1+Interest Return/100)] -1} ×100%

= {[( 1+ -1.8220% ) × (1+ -0.0337%)] -1} ×100%
= -1.85513165%

That is the number shown in figure 3.

Total Return calculation

The calculation is similar to Carry Return, but the interest return index is based on one currency
only not based on the interest differentials of 2 currencies. This interest return only uses the
accumulated interest and ignores the spot movement.

The Interest Return formula :

IRt = IRt-1 ( 1+ Interestt )

EUDRC BDSR Curncy USDRC BDSR Curncy EUDRC/(260x100)

Date 3M depo rate Date 3M depo rate
1/1/1999 3.215 1/1/1999 4.94 0.000123654
1/4/1999 3.195 1/4/1999 4.94 0.000122885
1/5/1999 3.175 1/5/1999 4.94 0.000122115
1/6/1999 3.1537 1/6/1999 4.94 0.000121296
1/7/1999 3.175 1/7/1999 4.94 0.000122115
1/8/1999 3.175 1/8/1999 4.88 0.000122115

Page 5
 EUR IR index Interest
Date return
1/1/1999 1.000123654 =1+0.000123654
1/4/1999 1.000246554 =1.000123654*(1+0.000122885)
1/5/1999 1.000368699 =1.000246554*(1+0.000122115)
1/6/1999 1.00049004 =1.000368699*(1+0.000121296)
1/7/1999 1.000612215 =1.00049004*(1+0.000122115)
1/8/1999 1.000734405 =1.000612215*(1+0.000122115) 0.061067511

The Interest return of EUR deposit :

= [ ( IR(endDate 01/08/09) - IR(startDate 01/01/09) ) / IR(startDate 01/01/09) ] × 100%

= [ (1.000734405 – 1.000123654) / 1.000123654 ] × 100%
= 0.061067511%

Finally to calculate the Total Return :

Total return is the multiple of Spot return and Interest return, as currency investor gains in FX
movement as well as interests income.

Total Return = {[(1+Spot return/100)×(1+Interest Return/100)] -1} ×100%

= {[( 1+ -1.8220% ) × (1+ 0.061067511%)] -1} ×100%
= -1.762045139%

That is the number shown in figure 4.

Figure 4. WCRS<GO> World Currency Ranker in Total Return

Page 6
 2. Volatility
What is Volatility ?

It is a measurement of risk over a certain time period.

Figure 5. High volatility versus Low volatility

Volatility is a magnitude of how much price move up and down in percentage term in a specific
time horizon, in annualized terms, without any directional indication. An instrument that is more
volatile is likely to increase or decrease in value more than the one that is less volatile. Volatility
does not bias for up or down price movement but just reflects the degree of risk faced by someone
with exposure to that variable.

Option traders and quantitatives analysts have more variations on the word ‘Volatility’. The
variations on volatility include historical volatility, implied volatility, historical implied volatility,
forward implied volatility, forward forward volatility, instantaneous volatility, normal volatility,
lognormal volatility, local volatility and breakeven volatility.

Interpretation of volatility

 Historical volatility = 10% means standard deviations of daily change is 10% annually to
the mean.
 If an option is priced $25 with implied volatility 10, projecting to move 10% (= $2.5) up
and down from the strike within 1 year.
 When a $40 stock has 90 Days volatility = 10, 95% probability that the price of stock with
be within the range from $35.39 [= 40-(40×10%)(90/260)(1.96)] to $44.61 [=
40+(40×10%)(90/260)(1.96)] in the coming 90 trading days.
 260 days is the default number of trading days per annual in Bloomberg, that is equal to 52
weeks multiple to 5 weekdays.
 Suppose a Call option has strike $100, implied volatility =20 and Option price = $30. The
underlying stock price is expected to move up to $120 [= $100×(1+20%)] and down to $80
[= $100×(1-20%)] within 1 year, the breakeven price = $130 (= $100+$30). Since the
estimated high price level is $120 and is smaller than the breakeven level $130, this option
will have very little probability to make profit at maturity.

Page 7
Type of Volatility

Historical volatility

Historical volatility is the standard deviation of the logarithmic historical price change of a security
within a specific time range, expressed as annualized percentage. It is used particularly to
distinguish between the actual volatility of price in the past and the current volatility implied by
the market.
Historical volatility is not a forecast of future volatility, which solely quantifies the level of
annualized standard deviation observed over a specified period of time using standard statistical
calculation. However, historical volatilities are sometimes used as guides in pricing an option that
is not traded on an exchange (e.g. OTC options).
10-day price volatility represents the annualized standard deviation of relative price changes,
calculated from the sample of 10 most recent trading day closing prices.
Historical volatility is used when trader believes the trend in market movement will persist.

Realized volatility

In VOLC<GO>, Realized volatility is the standard estimator for the square of the volatility
parameter in finance. If used to hedge a variance swap, it gives zero expected Profit-&-loss.
Recently, a new class of estimator for volatility has developed, which use intraday information,
such as highs and lows, to increase the efficiency of the estimation. On simulated Geometric
Brownian Motion processes, these methods have efficiencies which are around 8 times greater than
the standard estimators, above. They do depend on some features of Brownian motions, but they
are not as dominant on processes with time-varying drift, or jumps.
If there is no such a clear trend in market movement and prices just vary within a boundary,
Realized volatility is more suitable, especially in the intraday return or daily return.

Implied volatility

Implied volatility is the market’s predication of expected volatility and is indirectly calculated from
current option prices using an option pricing model, such as Black-Scholes or the binomial. In
essence, this is the market’s volatility forecast for the underlying security during the remaining life
of the option. This is also called option volatility.
Implied volatility is based on the underlying security’s price, listed option price, strike, time to
expiration, interest rates and retrieved from the option model, Black-scholes for European option,
Trinomial from American option, by trail and error method.
For listed options whose price is determined in the marketplace, the associated implied volatility
can be compared to the historical volatility as a rich or cheap indication. If the implied volatility is
traded bigger than the historical volatility, the listed option is consider expensive.

Volatility can be traded directly in today’s markets through options and variance swaps. In general,
volatility trading is a type of trading strategy that involves the movement in the underlying price.
So, if you consider market is quiet and security is lack of direction, you may buy volatility by
buying option in order to make profit in the volatile market in the future.

Page 8
Volatility calculation

Historical volatility calculation

In {HVT<GO>}, the historical volatility is calculated using standard statistical techniques on a

specific sample of historical prices. For example, 10-day close volatility is computed from the most
recent 10 days closing prices.
{HVT<GO>} calculates the volatility of the underlying securities log-normally using the
assumptions of most standard option pricing models. The N-day pricing volatility as a specific date
is the unbiased standard deviation of the most recent N-1 logarithmic daily returns, multiplied by
the annualized factor, and expressed as a percentage. Logarithmic daily return is the log of the
quotient of one day’s price divided by the prior day’s price. This algebraically the same as the
difference of the logs of the individual prices.

Volatility = 100 × √Trading days per year × √ { 1 ∑ u2 - 1 ( ∑u )2 }

(n-1) n(n-1)
where n = N-1 (the number of daily returns) and
u = the different of the logs of daily prices

Table 6.
EUR Curncy X
Date Close Log(P/P-1) X2 (X - avgX)2
1 8/6/2009 1.4345 -0.0041045 1.68469E-05 2.75659E-05
2 8/5/2009 1.4404 -0.00027766 7.70962E-08 2.02633E-06
3 8/4/2009 1.4408 -0.00027759 7.70534E-08 2.02611E-06
4 8/3/2009 1.4412 0.010813179 0.000116925 9.34577E-05
5 7/31/2009 1.4257 0.01284784 0.000165067 0.000136937
6 7/30/2009 1.4075 0.001777778 3.1605E-06 3.99361E-07
7 7/29/2009 1.405 -0.00829292 6.87725E-05 8.909E-05
8 7/28/2009 1.4167 -0.00457763 2.09547E-05 3.2758E-05
9 7/27/2009 1.4232 0.002110151 4.45274E-06 9.29917E-07
10 7/24/2009 1.4202 0.004162998 1.73306E-05 9.10331E-06
11 7/23/2009 1.4143 -0.00542962 2.94808E-05 4.32366E-05
12 7/22/2009 1.422 -0.00042185 1.77959E-07 2.45762E-06
13 7/21/2009 1.4226 -0.00035141 1.23487E-07 2.24171E-06
14 7/20/2009 1.4231 0.009106052 8.29202E-05 6.33652E-05
15 7/17/2009 1.4102 -0.00325664 1.06057E-05 1.93817E-05
16 7/16/2009 1.4148 0.002902143 8.42244E-06 3.08464E-06
17 7/15/2009 1.4107 0.009973724 9.94752E-05 7.79317E-05
18 7/14/2009 1.3967 -0.00078726 6.19779E-07 3.73683E-06
19 7/13/2009 1.3978 0.003009245 9.05556E-06 3.47232E-06
20 7/10/2009 1.3936 -0.00600946 3.61136E-05 5.11982E-05
21 7/9/2009 1.402 ΣX ΣX 2
Σ(X - avgX)2
Total 0.022917 0.000691 0.0006644

Page 9
 Daily σX 2 = [Σ(X - avgX)2 /(20-1)]0.5
= [0.0006644 /(20-1)]0.5
= 0.005913411

Daily σX 2 (2600.5) = (0.005913411) × (2600.5)

= 0.095350887
= 9.535%

Excel formula =STDEV(D10:D8)*SQRT(260) 0.095350887

EUR Curncy in HVT<GO>, N=21 9.535%

That is the number shown in figure 7.

Figure 7. EUR<Crncy> HVT<GO> with N 21 Days

Realized volatility calculation

The calculation is very similar to historical volatility, but Realized volatility has assumed that the
summation of the mean of daily log return equal to Zero. Therefore, the expected return is always
zero. It is known as Risk-Neutral Adjustment to historical volatility.

σ2= 1 ∑ { ln Sn – ( r – d ) δt }2
(n-1) δt Sn-1

Page 10
 Implied volatility calculation

For Commodities, currency and index futures, Bloomberg uses the trade matched underlying price
and the last trade option price in volatility calculations, using the option formulas by trial and error.

Rollover implied volatility calculation :

The Call (or Put) implied volatility is derived from a weighted average of the vola of 2
options closest to the ATM strike, which are the 2 most active Call options (or Put options)
but with life not less than 20 business days to maturity. The implied volatility is weighted
by moneyness.

To calculate the weighting :

Underling price = 113.75, 2 options strikes = 110, 115
2 implied volatility of those strikes = 36.719, 35.698 respectively
Absolute value of (Strike – Underlying price) = 3.75, 1.25.
Total value = 3.75+1.25 = 5
Weightings = (5-3.75)/5, (5-1.25)/5
= 0.25, 0.75

Implied volatility = 36.719×(0.25) + 35.698×(0.75)

= 35.95325

Volatility features

Volatility increases as time increases, because the price will be farther away from the initial price
in a longer period. Consequently, volatility increases option price. Higher volatility, larger price
move up and down, bigger probability to reach the strike level, option becomes more expensive.

At-the-money option has the lowest implied volatility, Out-of-money option and In-the-money
option will have the same volatility level according to the moneyness. Volatility curve shows
different level of volatility with different distance to strike point, and that is known as Smile curve.

Figure 8. Smile curve

Implied Volatility surface

Page 11
Bloomberg generic BGN volatility surface are real-time consensus estimates of the current traded
level of implied volatility for FX options. Those estimates are on implied volatility quotes from
many major banks and brokers for many different currencies.

Currently, the Black-Scholes volatility surface interpolation for the FX is implemented in the
Bloomberg through the {OVDV<GO>} function. This information is also shared with
{OVML<GO>}, the function used to price FX and Commodity options.

BGN mid volatility surfaces are calculated as a weighted average of contributor quotes and
interpolated contributor quotes. The calculation proceeds from start to end deals with volatility
quotation not as individual securities, but as parts of a full volatility surface. Strength weighted to
different contributors in different tenors and moneyness because some are good in short term and
some are good in long term.

However, volatility is far from constant, so there is no way to have a flat volatility surface. When
central bank interventions occur, volatilities jump. The jumps have more impact to short term
options than to long term options. In additional, market players have different preference to
different tenors, different strikes and different markets. More players participate in a specific tenor
or market will have a higher volatility. 3 Dimensional and 2 Dimensional real-time graphs can be
plotted in {OVDV<GO>}, which allows us to identify the option market behaviour easily. Those
graphs show the volatility surface versus life to expiration and strike level physically, and they are
rough surfaces rather than flat (or smooth) one.

Figure 9. OVDV<GO> shows volatilities, risk reversals and butterflies for different tenors

{OVDV<GO> follows the market standard to include premium in Delta for most currency pairs
except EUR/USD, GBP/USD, AUD/USD, NZD/USD and precious metals. Spot Delta is used for
maturity below 1 year, and Forward Delta is used for maturity at or beyond 1 year. Delta neutral
straddle (DNS) is used in ATM volatility, that ATM strike is the strike for which a Straddle will
have zero Delta, will have no different for Delta includes or excludes premium for both Spot and
Forward Delta. See chapter 15 for detail of Straddle.
Moneyness

Page 12
Moneyness is the description of the distance between Strike price and underlying price. The
formula is :
Moneyness = Strike × 100%
Underlying price

At-the-money option has Strike equal to Underlying price, so Moneyness (ATM) is 100%.

If USD/JPY spot rate is 90.00 and option strike is 99.00, that option is 110% Moneyness. So, it is
Out-of-money for Call USD Put JPY option but In-the-money for Put USD Call JPY option.

Alternatively, when USD/JPY spot rate is 90.00 and option strike is 81.00, that option is 90%
Moneyness. It is In-the-money for Call USD Put JPY option but Out-of-money for Put USD Call
JPY option.

Delta

Delta is the expected change in the value of an option, per dollar change in the market price of the
underlying asset. For example, a Call option with a delta of 0.50 means $0.50 increase in option
premium for $1 rise in the underlying price. Or, if option has a delta of 25 and spot move 1%,
option premium is expected to move by 0.25 ×1% = 0.25% (or 25 basis points) of the notional.
So, Delta is the approximate change in option premium for 1 unit change in the underlying currency.

Change in premium / Notional

The approximate Delta =
Change in Spot rate

Delta is always positive for Call option. As the underlying price goes higher, the Call option
becomes deeper In-the-money and more value.

Figure 10. Delta of XAU/USD currency Call option at strike 835

This green line shows the intrinsic value of option change according to the Gold price level. So, if
a Call option is Out-of-money (when Strike price > underlying price), Delta is always equal to zero.
No matter the underlying price moves up or down, the intrinsic value of option is not affected.
However, if the Call option is In-the-money (when Strike price < underlying price), Delta is always
Page 13
equal to +1 (or +100%). $1 increases in underlying price trigger $1 rises in option premium and
vice versa.

The yellow line indicates the intrinsic value and time value of option change according to the Gold
price. The time value smooths out the Delta.

Delta is always negative for Put option. As the underlying price goes lower, the Put option becomes
deeper In-the-money and more value.

Figure 11. Delta of XAU/USD currency Put option at strike 835

This green line shows the intrinsic value of option change according to the Gold price level. So, if
a Put option is Out-of-money (when Strike price < underlying price), Delta is always equal to zero.
No matter the underlying price moves up or down, the intrinsic value of option is not affected.
However, if the Put option is In-the-money (when Strike price > underlying price), Delta is always
equal to -1 (or -100%). $1 drops in underlying price trigger $1 rise in option premium, that is
negative correlated.

The yellow line indicates the intrinsic value and time value of option change according to the Gold
price. The time value smooths out the Delta.

♥ +25% Delta (or >100% Moneyness) Call option is an Out-of-money option,

♥ +50% Delta (or 100% Moneyness) Call option is At-the-money option
♥ +75% Delta (or <100% Moneyness) Call option is In-the-money option.

♥ -25% Delta (or <100% Moneyness) Put option is an Out-of-money option

♥ -50% Delta (or 100% Moneyness) Put option is At-the-money option
♥ -75% Delta (or >100% Moneyness) Put option is In-the-money option.
25D represents 25 Delta. By standard practice, strikes are quoted as their corresponding option
Deltas, typically at 25 Delta and 10 Delta. Since market accepts the concept of smile curve, that
plots volatility versus moneyness, and symmetric behaviour, so 25D equal to 75D and 10D equal
to 90D.

Page 14
According to the Smile curve theory, Call Delta = 100% - Absolute[ Put Delta ]
So, 25 Call Delta = 75 Put Delta (in positive value)

In {OVDV<GO>}, volatility quotes for a fixed maturity may come in either Risk-
reversal/Butterfly (RR/BF) or Call/Put (C/P) format. In the C/P format, the volatilities of the
corresponding Call or Put are quoted directly together with the ATM volatility, whereas in the
RR/BF format we get the ATM volatility quotation together with quotations of Risk-reversals and
Butterflies for each Delta. The relationship between calls, puts, risk-reversals and butterflies are as
follow :

RR = C vola – P vola C vola = ATM vola + BF + RR/2

BF = (C vola +P vola)/2 – ATM vola P vola = ATM vola + BF – RR/2

25D RR vola, the 25 delta Risk Reversal, is the volatility spread between +25 Delta Call and -25
Delta Put, which both are In-the-money options.

Positive Risk reversal (RR) will display when the volatility of Call option is greater than the
volatility of Put option. Since more traders are participating and generating a higher volatile price
in the Call option contracts than in the Put option contracts, positive RR indicating Bull market of
the underlying currency pair. For example, EUR/USD has positive RR, meaning that many traders
are interested in EUR Call option than EUR Put option, so EUR currency is likely to appreciate.

Alternatively, negative Risk reversal (RR) will display when the volatility of Put option is greater
than the volatility of Call option, meaning more traders are interested in participating the Put option
contracts than in Call option contracts. Therefore, the option prices of Put contracts are highly
volatile, that also implying market is Bearish to the underlying currencies pair. For example, when
EUR/USD has negative RR, more traders are interested in EUR Put option than EUR Call,
indicating that EUR is likely to depreciate.

OVDV table shows the call-put spread with different Delta and different maturity.
Out-of-Money Delta < 50%, and far OFM Delta = 0%
In-the-Money Delta > 50%, and deep ITM Delta = 100%
50D : Delta = 50% = At-the-Money option (ATM)
ATM (50D) : implied volatility for Delta neutral means 50-50 chance the option is In-the-
money

Figure 12. Delta of Call option

Page 15
 Delta

100%

50% Strike

0 Underlying price
OFM ATM ITM

Risk Reversals, RR, capture the skewness in FX market. Skewness is a measure of symmetry. If
the distribution is symmetrical with regards to up-moves and down-moves, it will be a bell-shaped
curve, and skewness equals to zero.

Figure 13. Skewness

(Risk Reversal) RR = Vola (Call) – Vola (Put)

RR > 0, when Vola (Call) > Vola (Put)
Bullish market, as more Call buyer than Put buyer
RR < 0, when Vola (Call) < Vola (Put)
Bearish market, as less Call buyer than Put buyer

Skew to the left, that is a positive skew, means market players are concentrating on the left and
more interested in low strike option. It is due to greater Delta value, option price will follow more
closely to the underlying price, for deep In-the-money options.

In figure 14, {EBVL<GO>} shows the JPY has skew to the right and that is a negative skew.
Traders are interested to a higher strike level, meaning they like to buy JPY sell USD at a higher
than USD/JPY spot price 89.59.

Page 16
Figure 14. JPY<Crncy> BEVL<GO> shows the skewed Smile curve

Skew in normal distribution tells the mean of observation shift from central; lying to Left Hand
Side is positive skew, to Right Hand Side is negative skew but lying in the middle is no skew.

25D BF volatility, the 25 delta Butterfly, is the volatility combination of half a +25 Delta Call and
half of a -25 Delta Put then minus one At-the-money option. The other version gives the BF
volatility as the Strangle volatility minus ATM volatility (see change 16 for Strangle detail). It
represents the level of kurtosis or the thickness in the distribution tails. Kurtosis is a measure of
whether the data are peaked or flat relative to a normal distribution. For normal distribution,
Kurtosis equals to 3. High kurtosis tends to have a distinct peak near the mean, decline rather
rapidly, and have heavy tails. So, fatter tails means volatilities are large for Out-of-money and In-
the-money options. Traders are not only interested in At-the-money option but also trading other
options and expecting big gain or big loss in return.

Low kurtosis tends to have a flat top near the mean rather than a sharp peak. Underlying fluctuates
in a reasonable range between the mean.

Kurtosis- leptokurtic is important scenario in option market, as usually volatilities are large when
options are In-the-money and Out-of-money than the volatility of At-the-Money. Therefore,
volatility is not completely lognormal distributed, meaning that Black-scholes model assumptions
cannot be achieved.

Figure 15. Kurtosis

Page 17
Kurtosis and skewness do exist in reality. Normally, large volume is traded at the supporting level
as well as resistant level in FX market. That strong supporting level at low price is positive skewed.
Whereas, the big resistant level at high price, it is negative skewed.
The most common factors that cause Kurtosis and skewness are central bank interventions,
surprising economic data release, financial crisis and political turbulences, as jumps and dramatic
moves in FX price are the results.

Figure 16. JPY<Crncy> XCRV<GO>

{XCRV<GO>} plots the FX forward curve, Outright curve, interest rate curve, 25D Risk Reversal
and 25D Butterfly of most currencies. Its also displays forecasted spot rates that are contributed by
many analysts, that can be found in {FXFC<GO>}, the FX forecast page.

The white line in figure 16 is the Risk Reversal curve of 25 Delta JPY option. Higher spread
between Call and Put in the shorter tenor than it is in the longer tenor, indicating market is full of
short term traders and central bank interventions also cause big impact to shorter tenor.

Page 18
Moreover, the red line is the Butterfly curve of 25 Delta JPY option. It presents a smaller Call-Put
spread in shorter tenor than in the longer tenor, because short tenor options have more liquidity.
Option traders are less cautious to take short term than long term risk. However, less participants
in longer tenor, market quotation may be difficult to obtain. So traders will eventually take over
the position with no choice. A wide spread is necessary to compensate the longer tenor unfavour
scenario, producing higher butterfly values.

Formula of mean, variance, skewness and kurtosis :

Mean μ = E[r]

Variance σ2 = E[( r – μ )2 ]

E[( r – μ )3 ]
Skewness s =
σ3

E[( r – μ )4 ]
Kurtosis k = -3
σ4

CDS , Spot and Volatility

The value of a currency is affected by many economic and political factors, the instability in a
country often leads to erode the currency return as well as worsen the sovereign credit quality. In
order to protect the credit of sovereign debt, central bank will purchase own currency from FX
market and rise interest rate, whereas bond investors will purchase protection from Credit default
swap. Therefore, CDS spreads, FX spot and FX options implied volatility will tend to have
correlations.

Figure 17. CDFX<GO> with Brazil CDS spreads and BRL 1month ATM Volatility

Page 19
You can easily observe that CDS spreads and FX option volatilities are positively corrected,
indicating that option market is quiet when CDS spreads are narrow and environment is stable but
option market is resilient when CDS spreads increase.

Figure 18. USD/KRW spot versus USDKRW 1year ATM volatility versus 5year Korea CDS

The correlation between FX spot and CDS are significant in exotic currencies, such as BRL, CLP,
KRW and CNY. Nonetheless, G7 currencies, such as JPY, EUR and GBP, do not prove the
correlation of CDS spreads to FX spot, indicating that those currencies performance are not only
derived by fundamental issues but also by speculation purposes.

Page 20
 3. Correlation
Correlation coefficient indicates the strength and direction of a linear relationship between 2
random variables.

The correlation has value between -1 to +1. The closer the coefficient is the either -1 or +1, the
stronger the correlation between the variables. If correlation is negative, the 2 variables have
inversely relationship. They are moving in opposite direction. If correlation is positive, the 2
variables have positive relationship. They are moving in same direction. When correlation is equal
to 1, they are perfectly correlated, moving together.

Correlation calculation

corr ( X, Y ) = ρX,Y
__ __
ρX,Y = Cov ( X, Y )
____________ = [( X – X )( Y – Y )]
E_________________
σX σY σX σ Y
__ __
where ρX,Y is the correlation coefficient between 2 variables X and Y with expected values µX , µY
and standard deviation σX , σY ; “E” is the expected value and “Cov” means covariance.

ρX,Y = N Σ X Y – ( Σ X )( Σ Y )
_____________________________________
√[ N Σ X2 – ( Σ X )2 ] √[ N Σ Y2 – ( Σ Y )2 ]

where :
N = number of pairs of variables
ΣXY = sum of the products of variables
ΣX = sum of X variables
ΣY = sum of Y variables
Σ X2 = sum of squared X variables
Σ Y2 = sum of squared Y variables

Correlation by value

Value means no transformation on data, simply uses the data in the Data column. Value typically
implies that the resulting calculation will be affected by auto-correlation, i.e. the previous values
significantly affect the current values. Correlation by value method is commonly used in statistical
analysis.

Page 21
Figure 19. CORR<GO> → set to Calculate On VALUE

Figure 20. Correlation by Value result table

Calculation of correlation by value

EUR Date Close GBP Date Close XY X2 Y2

1 2/13/2009 1.2863 2/13/2009 1.4355 1.84648365 1.65456769 2.06066025
2 2/12/2009 1.2861 2/12/2009 1.4268 1.83500748 1.65405321 2.03575824
3 2/11/2009 1.2906 2/11/2009 1.4395 1.8578187 1.66564836 2.07216025
4 2/10/2009 1.2913 2/10/2009 1.4542 1.87780846 1.66745569 2.11469764
5 2/9/2009 1.3003 2/9/2009 1.49 1.937447 1.69078009 2.2201
6 2/6/2009 1.2941 2/6/2009 1.4786 1.91345626 1.67469481 2.18625796
7 2/5/2009 1.2792 2/5/2009 1.4611 1.86903912 1.63635264 2.13481321

Page 22
 8 2/4/2009 1.2849 2/4/2009 1.4469 1.85912181 1.65096801 2.09351961
9 2/3/2009 1.304 2/3/2009 1.4458 1.8853232 1.700416 2.09033764
10 2/2/2009 1.2843 2/2/2009 1.4265 1.83205395 1.64942649 2.03490225
11 1/30/2009 1.2812 1/30/2009 1.4539 1.86273668 1.64147344 2.11382521
12 1/29/2009 1.2954 1/29/2009 1.4302 1.85268108 1.67806116 2.04547204
13 1/28/2009 1.3165 1/28/2009 1.425 1.8760125 1.73317225 2.030625
14 1/27/2009 1.3161 1/27/2009 1.413 1.8596493 1.73211921 1.996569
15 1/26/2009 1.3189 1/26/2009 1.3993 1.84553677 1.73949721 1.95804049
16 1/23/2009 1.2969 1/23/2009 1.3795 1.78907355 1.68194961 1.90302025
17 1/22/2009 1.3001 1/22/2009 1.3877 1.80414877 1.69026001 1.92571129
18 1/21/2009 1.3023 1/21/2009 1.3955 1.81735965 1.69598529 1.94742025
19 1/20/2009 1.2907 1/20/2009 1.3929 1.79781603 1.66590649 1.94017041
20 1/19/2009 1.3068 1/19/2009 1.4419 1.88427492 1.70772624 2.07907561
21 1/16/2009 1.3266 1/16/2009 1.4736 1.95487776 1.75986756 2.17149696
22 1/15/2009 1.3117 1/15/2009 1.4641 1.92045997 1.72055689 2.14358881
23 1/14/2009 1.3191 1/14/2009 1.4612 1.92746892 1.74002481 2.13510544
24 1/13/2009 1.3184 1/13/2009 1.4502 1.91194368 1.73817856 2.10308004
25 1/12/2009 1.3362 1/12/2009 1.4822 1.98051564 1.78543044 2.19691684
26 1/9/2009 1.3473 1/9/2009 1.5162 2.04277626 1.81521729 2.29886244
27 1/8/2009 1.3702 1/8/2009 1.5216 2.08489632 1.87744804 2.31526656
28 1/7/2009 1.3645 1/7/2009 1.5099 2.06025855 1.86186025 2.27979801
29 1/6/2009 1.3537 1/6/2009 1.4916 2.01917892 1.83250369 2.22487056
30 1/5/2009 1.3636 1/5/2009 1.4699 2.00435564 1.85940496 2.16060601
31 1/2/2009 1.3921 1/2/2009 1.4547 2.02508787 1.93794241 2.11615209
32 1/1/2009 1.4042 1/1/2009 1.4671 2.06010182 1.97177764 2.15238241

42.1336 46.3861 61.0947702 55.5107264 67.2812628

ΣX ΣY Σ XY ΣX 2
Σ Y2

NΣXY = 32 × 61.0947702
( Σ X )( Σ Y ) = 42.1336 × 46.3861
√[ N Σ X – ( Σ X ) ] = [ ( 32 × 55.5107264 ) – ( 42.1336 ) 2 ] 0.5
2 2

√[ N Σ Y2 – ( Σ Y )2 ] = [ ( 32 × 67.2812628 ) – ( 46.3861 ) 2 ] 0.5

ρX,Y = N Σ X Y – ( Σ X )( Σ Y )
_____________________________________
√[ N Σ X2 – ( Σ X )2 ] √[ N Σ Y2 – ( Σ Y )2 ]

ρX,Y = ( 32 × 61.0947702 ) – ( 42.1336 × 46.3861 )

[( 32 × 55.5107264 )– (42.1336 ) 2 ] 0.5 × [( 32 × 67.2812628 )– (46.3861 ) 2 ] 0.5

ρX,Y = 0.51125835

Page 23
The correlation of GBP and EUR calculated from the closing price value is 0.511. You can find it
in figure 20.

Correlation by different

Different is the change of 2 data, so there is one data point less than the number of data point of
Value. It analyzes the absolute change in values over one period for each pair. Correlation by
different method is used in analyzing spread trade or oscillation.

Figure 21. CORR<GO> → set Calculate On Difference

Figure 22. Correlation by Different result table

Page 24
Calculation of correlation by different

EUR GBP
Date Close Different Close Different XY X2 Y2
1 2/13/2009 1.2863 1.4355
2 2/12/2009 1.2861 0.0002 1.4268 0.0087 1.74E-06 4E-08 7.569E-05
3 2/11/2009 1.2906 -0.0045 1.4395 -0.0127 5.715E-05 2.025E-05 0.00016129
4 2/10/2009 1.2913 -0.0007 1.4542 -0.0147 1.029E-05 4.9E-07 0.00021609
5 2/9/2009 1.3003 -0.009 1.49 -0.0358 0.0003222 8.1E-05 0.00128164
6 2/6/2009 1.2941 0.0062 1.4786 0.0114 7.068E-05 3.844E-05 0.00012996
7 2/5/2009 1.2792 0.0149 1.4611 0.0175 0.00026075 0.00022201 0.00030625
8 2/4/2009 1.2849 -0.0057 1.4469 0.0142 -8.094E-05 3.249E-05 0.00020164
9 2/3/2009 1.304 -0.0191 1.4458 0.0011 -2.101E-05 0.00036481 1.21E-06
10 2/2/2009 1.2843 0.0197 1.4265 0.0193 0.00038021 0.00038809 0.00037249
11 1/30/2009 1.2812 0.0031 1.4539 -0.0274 -8.494E-05 9.61E-06 0.00075076
12 1/29/2009 1.2954 -0.0142 1.4302 0.0237 -0.0003365 0.00020164 0.00056169
13 1/28/2009 1.3165 -0.0211 1.425 0.0052 -0.0001097 0.00044521 2.704E-05
14 1/27/2009 1.3161 0.0004 1.413 0.012 4.8E-06 1.6E-07 0.000144
15 1/26/2009 1.3189 -0.0028 1.3993 0.0137 -3.836E-05 7.84E-06 0.00018769
16 1/23/2009 1.2969 0.022 1.3795 0.0198 0.0004356 0.000484 0.00039204
17 1/22/2009 1.3001 -0.0032 1.3877 -0.0082 2.624E-05 1.024E-05 6.724E-05
18 1/21/2009 1.3023 -0.0022 1.3955 -0.0078 1.716E-05 4.84E-06 6.084E-05
19 1/20/2009 1.2907 0.0116 1.3929 0.0026 3.016E-05 0.00013456 6.76E-06
20 1/19/2009 1.3068 -0.0161 1.4419 -0.049 0.0007889 0.00025921 0.002401
21 1/16/2009 1.3266 -0.0198 1.4736 -0.0317 0.00062766 0.00039204 0.00100489
22 1/15/2009 1.3117 0.0149 1.4641 0.0095 0.00014155 0.00022201 9.025E-05
23 1/14/2009 1.3191 -0.0074 1.4612 0.0029 -2.146E-05 5.476E-05 8.41E-06
24 1/13/2009 1.3184 0.0007 1.4502 0.011 7.7E-06 4.9E-07 0.000121
25 1/12/2009 1.3362 -0.0178 1.4822 -0.032 0.0005696 0.00031684 0.001024
26 1/9/2009 1.3473 -0.0111 1.5162 -0.034 0.0003774 0.00012321 0.001156
27 1/8/2009 1.3702 -0.0229 1.5216 -0.0054 0.00012366 0.00052441 2.916E-05
28 1/7/2009 1.3645 0.0057 1.5099 0.0117 6.669E-05 3.249E-05 0.00013689
29 1/6/2009 1.3537 0.0108 1.4916 0.0183 0.00019764 0.00011664 0.00033489
30 1/5/2009 1.3636 -0.0099 1.4699 0.0217 -0.0002148 9.801E-05 0.00047089
31 1/2/2009 1.3921 -0.0285 1.4547 0.0152 -0.0004332 0.00081225 0.00023104
32 1/1/2009 1.4042 -0.0121 1.4671 -0.0124 0.00015004 0.00014641 0.00015376

-0.1179 -0.0316 0.003327 0.005544 0.012107

ΣX ΣY Σ XY Σ X2 Σ Y2

NΣXY = 31 × 0.003327
( Σ X )( Σ Y ) = -0.1179 × -0.0316
√[ N Σ X2 – ( Σ X )2 ] = [ ( 31 × 0.005544 ) – ( -0.1179 ) 2 ] 0.5

Page 25
√[ N Σ Y2 – ( Σ Y )2 ] = [ ( 31 × 0.012107 ) – ( -0.0316 ) 2 ] 0.5

ρX,Y = N Σ X Y – ( Σ X )( Σ Y )
_____________________________________
√[ N Σ X2 – ( Σ X )2 ] √[ N Σ Y2 – ( Σ Y )2 ]

ρX,Y = ( 31 × 0.003327 ) – ( -0.1179 × -0.0316 )

[( 31 × 0.005544 )– (-0.1179 ) 2 ] 0.5 × [( 31 × 0.012107 )– (-0.0316 ) 2 ] 0.5

ρX,Y = 0.40879035

The correlation of GBP and EUR calculated from the closing price different is 0.4088. You can
find it in figure 22.

Correlation by percentage

Percentage is the percentage change to last value, that is the different between the 2 values then
divided by the last value. Also, it has one data point less than the number of data point of Value. It
analyzes the percentage change over one period for each pair. Correlation by percentage is used in
analyzing performance and widely understood as BETA calculation.

Figure 23. CORR<GO> → set Calculate On Percent

Page 26
Figure 24. Correlation by Percent result table

Calculation of correlation by percentage

EUR GBP
Date Close Percentage Close Percentage XY X2 Y2
1 2/13/2009 1.2863 1.4355
2 2/12/2009 1.2861 0.0155509 1.4268 0.6097561 0.00948225 0.00024183 0.3718025
3 2/11/2009 1.2906 -0.348675 1.4395 -0.8822508 0.30761882 0.12157428 0.77836644
4 2/10/2009 1.2913 -0.0542089 1.4542 -1.0108651 0.05479792 0.00293861 1.02184821
5 2/9/2009 1.3003 -0.692148 1.49 -2.4026846 1.66301323 0.47906881 5.77289311
6 2/6/2009 1.2941 0.4790974 1.4786 0.77099959 0.36938393 0.22953436 0.59444037
7 2/5/2009 1.2792 1.1647905 1.4611 1.19772774 1.39510189 1.3567369 1.43455174
8 2/4/2009 1.2849 -0.4436143 1.4469 0.98140853 -0.4353668 0.19679364 0.9631627
9 2/3/2009 1.304 -1.4647239 1.4458 0.07608245 -0.1114398 2.14541618 0.00578854
10 2/2/2009 1.2843 1.5339095 1.4265 1.35296179 2.07532098 2.35287842 1.83050562
11 1/30/2009 1.2812 0.2419607 1.4539 -1.8845863 -0.4559957 0.05854496 3.55166547
12 1/29/2009 1.2954 -1.0961865 1.4302 1.65711089 -1.8165026 1.20162486 2.74601651
13 1/28/2009 1.3165 -1.6027345 1.425 0.36491228 -0.5848575 2.56875795 0.13316097
14 1/27/2009 1.3161 0.0303928 1.413 0.8492569 0.02581132 0.00092372 0.72123728
15 1/26/2009 1.3189 -0.2122981 1.3993 0.97906096 -0.2078528 0.04507049 0.95856036
16 1/23/2009 1.2969 1.6963528 1.3795 1.43530265 2.43477972 2.87761296 2.06009369
17 1/22/2009 1.3001 -0.2461349 1.3877 -0.5909058 0.14544255 0.0605824 0.34916968
18 1/21/2009 1.3023 -0.1689319 1.3955 -0.5589394 0.0944227 0.02853798 0.31241331
19 1/20/2009 1.2907 0.8987371 1.3929 0.18666092 0.1677591 0.80772841 0.0348423
20 1/19/2009 1.3068 -1.2320171 1.4419 -3.3982939 4.18675636 1.51786624 11.5484016
21 1/16/2009 1.3266 -1.4925373 1.4736 -2.1511944 3.21073784 2.22766763 4.62763715
22 1/15/2009 1.3117 1.1359305 1.4641 0.64886278 0.73706301 1.29033804 0.42102291

Page 27
 23 1/14/2009 1.3191 -0.5609886 1.4612 0.19846701 -0.1113377 0.31470816 0.03938916
24 1/13/2009 1.3184 0.0530947 1.4502 0.75851607 0.04027315 0.00281904 0.57534662
25 1/12/2009 1.3362 -1.3321359 1.4822 -2.1589529 2.87601869 1.77458608 4.66107766
26 1/9/2009 1.3473 -0.82387 1.5162 -2.2424482 1.84748573 0.67876171 5.02857405
27 1/8/2009 1.3702 -1.6712889 1.5216 -0.3548896 0.59312302 2.79320646 0.12594662
28 1/7/2009 1.3645 0.4177354 1.5099 0.77488575 0.32369724 0.17450289 0.60044793
29 1/6/2009 1.3537 0.7978134 1.4916 1.22687047 0.97881371 0.63650622 1.50521116
30 1/5/2009 1.3636 -0.7260194 1.4699 1.4762909 -1.0718158 0.52710411 2.17943483
31 1/2/2009 1.3921 -2.0472667 1.4547 1.04488898 -2.1391664 4.19130102 1.09179298
32 1/1/2009 1.4042 -0.8617006 1.4671 -0.8452048 0.72831352 0.74252795 0.7143712

-8.6121148 -1.891193 17.33088 31.40646 56.75917

ΣX ΣY Σ XY Σ X2 Σ Y2

NΣXY = 31 × 17.33088
( Σ X )( Σ Y ) = -8.6121148 × -1.891193
√[ N Σ X – ( Σ X ) ] = [ ( 31 × 31.40646 ) – ( -8.6121148 ) 2 ] 0.5
2 2

√[ N Σ Y2 – ( Σ Y )2 ] = [ ( 31 × 56.75917 ) – ( -1.891193 ) 2 ] 0.5

ρX,Y = N Σ X Y – ( Σ X )( Σ Y )
_____________________________________
√[ N Σ X2 – ( Σ X )2 ] √[ N Σ Y2 – ( Σ Y )2 ]

ρX,Y = ( 31 × 17.33088 ) – ( -8.6121148 × -1.891193 )

[( 31 × 31.40646 )– (-8.6121148 ) 2 ] 0.5 × [( 31 × 56.75917 )– (-1.891193 ) 2 ] 0.5

ρX,Y = 0.4145450

The correlation of GBP and EUR calculated from the closing price percentage change is 0.4145.
You can find it in figure 24.

Correlation in HS<GO>

corr ( X, Y ) = ρX,Y
__ __
ρX,Y = Σ [( X – X )( Y –
____________________Y )]
(N-1) σX σY
X
__ = Value of currency X
X = Average value of currency X over the N data points
Y
__ = Value of currency Y
Y = Average value of currency Y over the N data points

Page 28
σX = Standard deviation of currency X for N data points
__
[ Σ ( X – X )2 ]
√
______________
=
(N–1)

σY = Standard deviation of currency X for N data points

__
[ Σ ( Y – Y )2 ]
=
√ _____________
(N–1)

These formulas are same as the calculations in {CORR<GO>}. However, the default period in
{HS<GO>} is set to 120 days. So, in order to reconcile the correlation between {HS<GO>} and
{CORR<GO>}, the Period has to be adjusted manually in the EDIT tab on the top red tool bar.

In my example in {CORR<GO>}, the data is in the period 01 Jan 2009 to 13 Feb 2009, there are
32 number of trading days. So, setting the Period = 32 days, the {HS<GO>} Correlation will be
same as the one in {CORR<GO>}.

Figure 25. Correlation by Value in HS<GO>

Correlation by Value in {HS<GO>} shows 0.511, that is same as the number in Figure 20.

Page 29
Figure 26. Correlation default setting in HS<GO>

Figure 27. Correlation by Percentage Different in HS<GO>

Page 30
Figure 28. Correlation Default setting in HS<GO>

Correlation by Percentage Different in {HS<GO>} shows 0.4155, that is same as the number in
Figure 24.

Note: treatment of missing data points are different in {CORR<GO>} and {HS<GO>}:
{CORR<GO>} will drop the corresponding point for securities with missing data, but {HS<GO>}
will carry the previous closing value forward to replace the missing data point. So, you may find
different result in these 2 functions when missing data points appear.

Page 31
 4. Option
Option contract is an forward agreement of a transaction on underlying security at a predetermined
date ( i.e. exercise date) and a predetermined price (e.g. strike price).

Buyer of option, who pays option price (i.e. premium), has the right but no obligation to exercise
the option. Buyer of Call option has no obligation to purchase underlying nor buyer of Put has
obligation to sell underlying security.

Writer of option, who receives premium, has the obligation to exercise the option when being
requested. Writer of Call has the obligation to sell the underlying when option is exercised. The
writer of Put has the obligation to purchase an underlying from buyer if the option is exercised.

If the option can only be exercised on a maturity date, this option is called European option. If the
option can be exercised any time up to a maturity date, this option is called American option. If the
option has a series of exercise dates, this is called Bermudan option.

Option is zero sum game

For Call option, maximum loss of buyer is the maximum gain of writer, that is the Call Premium.
Since the underlying can climb to a extreme level, Call option buyer can have infinite gain from
option writer, and buyer profit is the writer loss. Buyer profit is MAX [ Underlying Price – Strike
– Premium; -Premium ]. So, buyer starts to gain when [ Underlying Price – Strike – Premium >
0 ].
At Breakeven point, both buyer and writer will have no profit or loss. Breakeven level achieves
when [ Underlying Price – Strike – Premium = 0 ], in other words Breakeven price = Strike + Call
Premium.

Figure 29.

Call Zero Sum Game

P/L
Option Buyer payoff

gain
0 Underlying price
loss
Option price

Strike Strike + Option price

P/L
Option price
gain
0 Underlying price
loss
Option Writer payoff

For Put option, the maximum loss of buyer is the maximum gain of writer, that is the Option
Premium. Unlike the Call option, the maximum gain of Put option buyer is limit, as the underlying
stock price can never drop below zero. The maximum gain of Put buyer is the maximum loss of

Page 32
Put writer. Buyer profit is calculated as MAX [ Strike – Premium – Underlying price; -Premium ].
So, Put buyer gains when [ Strike – Premium – Underlying price > 0 ].
The Breakeven level is where [ Strike – Premium – Underlying price = 0 ], and the breakeven price
= Strike – Put premium.

Figure 30.

Put Zero Sum Game

P/L
Option Buyer payoff

gain
0 Underlying price
loss
Option price

Strike – Option price Strike

P/L
Option price
gain
0 Underlying price
loss
Option Writer payoff

Option concept

Call Put Exercise

In the money U>X U<X Yes

Buyer payoff +(U-X-C) +(X-P-U)
Writer payoff -(U-X-C) -(X-P-U)

At the money U=X U=X Yes / No

Buyer payoff -C -P
Write payoff +C +P

Out of money U<X U>X No

Buyer payoff -C -P
Writer payoff +C +P

where P = Premium of Put

C = Premium of Call
U = Underlying price
X = Strike price or exercise price

Page 33
 Intrinsic value

When option is OFM, option expired worthless, because you can obtain a better price in the
prevailing market. When option is ATM, option can be expired without value or exercised, since
you can get the same prices from both market and your counterparty. When option is ITM, option
should be exercised. As your counterparty has to offer you at a better than market price, that is the
Strike price, following to the option contract agreement, ITM option has value. The value is the
different between the current underlying price and the Strike price, and that is called Intrinsic value.

If you have a Call option on EUR/USD with Strike 1.3000 and Spot 1.3500, your option has USD
0.05 ( = 1.35 – 1.30) as Intrinsic value. For Notional EUR 1 million option, the intrinsic value =
USD 50,000 ( = €1,000,000 × (1.35 – 1.30) ).

Time value

Underlying price can hardly jump 100% within a day but that can be very common to have over
100% rise in 10 years period. So, the longer the time range, the further the underlying price goes,
the higher probability the strike price can be reached and the option becomes In-the-money.
Therefore, longer time range should deserve a option premium, that is known as Time value.
However, once the maturity date of an option is fixed, the Time value is eroded as times pass. Life
time of option goes shorter, then the time value declines. When option reaches maturity date cut
off time, Time value equals zero. It is Time decay.

Option premium consists of Time value and Intrinsic value. Even if the Intrinsic value is stable as
the underlying price does not frustrate, the option premium still decreases because of Time decay.

Option premium = Time value + Intrinsic value

as Time value ≥ 0,
so Option premium ≥ Intrinsic value

Since Option value is always Intrinsic value, over 90% of the option is not exercised. Traders prefer
to sell the options to the market and retrieve Time value and Intrinsic value together. If you exercise
the option, you will earn the Intrinsic value only.

In figure 32, if you buy EUR from market, your spot rate is 1.4511 and you pay U$1,000,000
×1.4511 for €1million. If you exercise EUR at strike price 1.450, you need to pay U$1million ×
1.45 for €1million then to earn the intrinsic value is U$1,100 (= 1,451,100-1.450,000). However,
if you sell this option to market, you get U$28,164 that includes Time value too.

In Bloomberg, option calculators measure time value by counting every second, so the Time default
setting in {TZDF<GO>} is an essential parameter.

Option formula

Page 34
FX option is calculated by Garman-Kohlhagen model and that is modified from Black-Scholes
model for European Stock Option. So, let start with BS first.

Black – Scholes (BS) model for European Stock option

The key assumptions of BS model are :

 The price of the underlying instrument St has a geometric (Brownian) continuous motion
with an constant drift μ (no jump) and constant volatility σ , and the price changes are log-
normally distributed.

dSt = μSt dt + σSt dWt

 Unlimited short selling of the underlying stock is possible.

 There is no arbitrage opportunity.
 Trading in the stock is continuous.
 There are no transaction costs or taxes.
 All securities are bought and sold in any fraction of a share.
 Investors can borrow and lend cash at a constant risk-free interest rate.
 Stock does not pay a dividend

The price C of a European Call option with exercise price K on a stock currently trading at price S
will have the right to buy a share of the stock at price K after T years. The constant interest rate is
r, and the constant stock volatility is σ.

C ( S,T ) = S Φ( d1 ) – Ke-rT Φ( d2 )
where

d1 = ln( S/K ) + ( r + σ 2/ 2 ) T
σ √T

d2 = d1 – σ √T

Φ is the standard normal cumulative distribution function.

Φ( d1 ) and Φ( d2 ) are the probability of exercise the underlying stock and the probability of
exercise the risk free asset respectively.

The price of a Put option is calculated by the Put-Call Parity :

P ( S,T ) = Ke-rT Φ( -d2 ) – S Φ( -d1 )
Put Call Parity defines a relationship between the price of a Call option and a Put option with an
identical Strike price and expiry day, under the assumption that no option is exercised before
expiration day. Therefore, it applies only to European option.

C (t) + X B (t,T) = P (t) + S(t)

where C (t) = value of the Call at time t

Page 35
 P (t) = value of the Put at time t
S (t) = value of Underlying stock
X = Strike price
B (t,T) = value of a bond that matures at time T. If a stock pay dividends, that should
be included in B (t,T) because option price are typically not adjusted for
ordinary dividends.

A portfolio of Call option and an amount of cash multiple to the present value of Strike has the
same expiration value as a portfolio of Put option with an Underlying stock. If the expiration values
of 2 portfolios are the same, their present values must also be the same.

Alternatively, C + PV (X) = P + S

C+[ X ]=P+S
(1+r)t
where C = current market value of the Call
P = current market value of the Put
PV (X) = present value of strike price
S = current market value of underlying

Figure 31. Put – Call Parity, 2 portfolios have identical expiration values

For American options, where you have the right to exercise before expiration, this affects the B
(t,T) term in the above equation. Put-Call parity only holds for American options if they are not
exercised early, since early exercise could cause a divergence in the present values of the 2
portfolios.

FX Option calculation

Page 36
Garman-Kohlhagen model is using the Black-Scholes model to price options on foreign exchange
rates, except that r is the different of interest rate in 2 currencies (instead of government bond yield)
and S is the Spot exchange rate.

FX Call vanilla option

Figure 32. EUR<Crncy> OVML SL<GO> → Call

Call option on EUR

d1 = ln( S/K ) + ( r + σ 2/ 2 ) T
σ √T

d2 = d1 – σ √T
EUR/USD spot rate = 1.4511
Strike = 1.4500
EUR interest rate = 4.620%
USD interest rate = 2.724%
r, USD interest rate – EUR interest rate = 2.724% - 4.620%
Volatility = 10.649%
Number of day to expiry = 91 days, (from 3 Sep – 5 Dec 2008)
Time to expiry = 91 / 365 = 0.249315068
d1 = { ln(1.4511 / 1.45 ) + [ ( 2.724 – 4.62)% + ( 10.749% 2/ 2 ) ]} ×(0.249315068)}
( 10.749% )  0.249315068

d1 = -0.057715
Page 37
d2 = -0.057715 – ( 10.749% )  0.249315068
d2 = -0.111386

Cumulative Normal distribution probability : N( d1 ) = 0.4769878

N( d2 ) = 0.4556550

Call option price :

C ( S,T ) = S Φ( d1 ) – Ke-rT Φ( d2 )
= [ 1.4511 e(-4.620% × 0.249315068) (0.4769878) ] – [ 1.45 e(-2.724% × 0.249315068) (0.4556550) ]
= 0.0280023 or 2.80%
That is shown is figure 32.

FX Put vanilla option

Figure 33. EUR<Crncy> OVML SL<GO> → Put

Put option on EUR

Cumulative Normal distribution probability : N( -d1 ) = 0.5230122

N(- d2 ) = 0.5443450
Put option price :

P ( S,T ) = Ke-rT Φ( -d2 ) – S Φ( -d1 )

=[1.4511 e(-2.724% × 0.249315068)(0.5443450)] – [1.45 e(-4.62% × 0.249315068)(0.5230122)]
= 0.0337067 or 3.37067%
That is shown in figure 33.
Interest rate in OVML

Page 38
Currency option involves 2 currencies, USD is one of the currencies in most of the cases. USD rate
sources are determined by your default setting in {SWDF<GO>}, whereas other currency is
calculated from FX forward market. OVML uses the spot rate, FX forward rate and first currency
(USD usually) Libor rate to derive the implied second currency rate (e.g. JPY).

Figure 34. JPY<Crncy> OVML SL<GO> Figure 35. BBAM1<GO>

JPY interest rate is calculated from FX forward market :

FX spot rate = 101.62
FX forward point = -67.72
USD interest rate = 4.05875% (Act/360)
Number of day in 3 months from 23 Oct 08 to 23 Jan 09 = 92
JPY interest rate = R% (Act/360)

According to the interest rate parity rule, the interest return gain in USD invested is same as the
return of USD converted into foreign currency at spot rate, deposited at foreign interest rate and
transferred back to into USD at FX forward rate under the same risk level.
USD1 × (1+ 4.05875% × 92/360) = USD1 × 101.62 × (1+ R% × 92/360) / (101.62-0.6772)
JPY interest rate, R% = 1.424033509%

Libor rate and forward implied rate, but not government bills bonds rate, are used to calculate in
OVML, because Libor rate and forward implied rate are the actual funding rate of inter-banks.
They are more appropriate to calculate option priced by banks. Only government body can borrow
money at Treasury bills bonds rate, that is known as Risk Free Rate.

Click into the dropdown menu in the Depo items, the following compounding frequencies are
available :
- Ann (annual)
- Semi (semi-annual)
- Cont (continuous)
- M Mkt (money market)

Figure 36. Annualized rate Figure 37. Continuous rate

Page 39
Figure 38. Semi-annual rate Figure 39. Money market rate

Figure 40. PFI <GO> Compound Interest Anlyzer to calculate JPY interest rates

PFI <GO> in figure 40 displays the interest rates that are calculated from the value of Present value
and Future value. The calculations are showed below:

Option is effective on 23 Oct 2008 and expire on 23 Jan 2009. Present value of cash flows is the
Notional of the option, JPY 1 million. Future value of cash flows is the principal plus interest
earned at money market interest rate, 1.424%, for 92 days.

Money market rate

Present value of Cash Flows is the value on the starting date = JPY 1 million
Future Value of Cash Flows is the value on the maturity date
= JPY 1 million × ( 1 + 1.424% × 92/365 ) = JPY 1,003,589.26. See figure 39.

Simple CD
Simple CD method is the calculation for most CDs, that annualizes the ratio of cash flows received
to the present value. Neither interest compounds nor interest on interest exits.
Simple CD rate = Money market rate = 1.424%. See figure 40.

Discount rate

Page 40
Discount method is used for most discount securities including Treasury Bills.
Holding rate = ( 1,003,589.26 – 1,000,000 ) / 1,003,589.26 × 100%
Annualized holding rate = ( 1,003,589.26 – 1,000,000 ) / 1,003,589.26 × ( 365 / 92 ) × 100%
Discount rate = 1.418907065%. See figure 40.
X / Year compound
X / Year compound method is similar to the semi-annual method but interest is compounded at the
frequency X. When X = 1, that is Annualized rate.
1/Year rate :
Number of day from 23 Oct 08 to 23 Jan 09 = 92
Number of day from 23 Jan 09 to 23 Apr 09 = 90
Number of day from 23 Apr 09 to 23 Jul 09 = 91
Number of day from 23 Jul 09 to 23 Oct 09 = 92
1+R% = (1 + 1.424% × 92/365)(1+ 1.424% × 90/365)(1+ 1.424% × 91/365)(1 +1.424% × 92/365)
R% = 1.431622012%. See figure 36 & 40.

Semi annual
Semi annual method is used for most bonds, assuming that in any given period interest is earned
on any interest previously earned that was not paid out.
(1 +1.431622012%) = (1 +R%/2)2
R% = 1.426534511%. See figure 38.

Continuous
Continuous method is the rate of return compounded continually, assuming interest earned begins
additional interest immediately without waiting until the end of a period.
(1 +1.431622012%) = (1 +R%/365)365
R% = 1.4214988%. See figure 37.

All the interest rates in different calculation formulas will generation the same future value by
maturity date. The Annualized rate, Continuous rate, Semi-annual rate are derived from the FX
forward implied interest rate.

Player strategy

US company, IBM, needs to make payment EUR 1million by 3 months time. IBM can have several
choices :
1. Purchase from spot market
2. Lock into a predetermined rate by using forward contract
3. Buy Call option

1. IBM will not consider exchange the currency from the spot market, as it requires the cash
immediately that may cause a short term liquidity problem to the company. Normally,
investors have their own opinion to the currency performance, so they won’t be satisfied to
translate the cash at current level.

2. Forward contract is a good hedging instrument, but it locks the payment amount too early
and investors have no chance to enjoy further favourable price movement.

Page 41
 For example, IBM expects EUR to strengthen and set a target rate 1.4700 to set the
maximum cost of exchange by 3 months time range. When the market is also foreseeing
EUR strengthening, the forward rate will also quote at high level and IBM will lock in a
forward rate that is around its target rate level. If EUR/USD climbs over 1.4700, IBM is
happy to have the forward contract. However, if EUR/USD did not rise as much as
expectation or even declined because of surprising weak economic sentiment, a lower FX
spot is traded in the market but IBM has to purchase EUR at 1.4700 according to contract
agreement. Once the forward contract is done, IBM must complete the deal on the maturity
date. Nothing can be changed. Without the forward contract, IBM can buy EUR at a lower
rate from the market. The problem is no more favourable outcome to IBM than 1.4700.

3. Consider IBM buy a Call option with Strike price at 1.4700, option premium has to be paid
in order to have the right to purchase EUR at 1.4700 on maturity. Premium is considered
as the cost of option. If EUR rises steady to 1.4700 level, IBM is indifferent to either
exercise or not to exercise the option as exchange rate 1.4700 are quoted by market players
and counterparty. If EUR accelerates to over 1.4700, IBM will exercise the option and buy
EUR at 1.4700 from counterparty. If EUR drops surprisingly to 1.4000, the Call option will
expire with no value as IBM can get a cheaper rate from market and save U$70,000. Since
when IBM buy EUR from market, it costs U$1,000,000×1.4000. Whereas, IBM has to pay
U$1,000,000×1.4700 when Call option is exercised.

Option has the average over forward contract because of the flexibility. Buyer can choose whether
or not to exercise the option according to the changing environment. Nevertheless, premium is the
cost of a right to exercise and is an expense, that will not be treated as a part of the transaction.

5. Futures

Futures contract is an agreement between two parties to buy or sell an asset at a certain time in the
future for a certain price, that is traded in exchange and governed by exchange. To make trading
possible, the exchange specifies certain standardized features of the contract, such as contract size,
trading hours and the like. Initial deposit is required and margin accounts are monitored by
exchange. This means that contracts can be easily bought and sold on the exchange without any
fears of default.

It is common knowledge that 98% of futures contracts are “closed out” before expiration, but what
does this entail? That means when you BUY (or LONG) a contract, you must SELL (or SHORT)
the same number of contracts to offset your position. This alleviates your responsibility of
accepting or making delivery. Currency contracts are financial futures which have no delivery
requirements if the contract is not “offset”. When the contract expires your account will be “marked
to market” (MTM) to reflect the current value of your underlying positions, meaning Cash settled.

Figure 41. Futures Contracts versus Forwards Contracts

Futures Forwards

Page 42
 • Traded on exchange • Traded Over the Counter
“open outcry”
• Standardized • Customized
• Marked to market • Cash payment upon delivery
• Limited credit risk • Credit risk of other party
• Offset before expiration • Intended for delivery
• Liquid • Illiquid (outside FX market)

Futures contact calculation

Figure 42. JYZ7<CRNCY>DES<GO> shows USD/JPY Dec 2007 futures contract

USD/JPY is indirect quote.

Underlying = USD/JPY fixing rate as of Last Trade day 17 Dec 07.

Contract size = ¥12,500,000
Conversion setting = ¥100 = $1
Value of 1 point (or 1%) = ¥ 12,500,000 ×1%
= ¥ 125,000
= $ 1,250

Figure 43. JYZ7<CRNCY>HP<GO> gives the historical closing price

Page 43
Contract price = 100 / spot
= 100 / 114.03 = 0.8770
Contract value = ¥ 12,500,000 × 0.8770
= ¥ 10,962,500
= $ 109,625

If you expect USD/JPY will decline, that JPY will appreciate, you should Buy
{JYZ7<Crncy>DES<GO>}. So, when USD/JPY dropped from 114.96 to 113.80, what is the P/L
of long 5 USD/JPY futures contracts ?

Price changed = (100/113.80) – (100/114.96)

= 87.87 – 86.99 = +0.88
Number of Tick moved : + 0.88/0.01 = +88 (up ticks)
P/L of 1 futures contracts = +88 × $12.50 (Tick value) = $1,100
P/L of 5 futures contracts = $ 5,500. Profit !

Figure 44. ECZ7<Crncy>DES<GO> shows EUR/USD Dec 2009 Futures contract

EUR/USD is direct quote.

Page 44
Underlying = EUR/USD fixing rate as of Last Trade day 14 Dec 09.
Contract size = €125,000
Convention setting : €1 = $1
Contract value = Current price × Value of 1 point
= 1.4707 × $125,000
= $183,837.50

If you expect EUR/USD to rise, that EUR will appreciate, you should buy
{ECZ9<Crncy>DES<GO>}. However, when the last closing price of EUR/USD futures contract
is 1.3600, what is the daily mark-to-mark (MTM) of long 10 contracts ?

Daily MTM is the daily P/L.

Daily price change : 1.3600 – 1.4707 = - 0.1107
Number of Tick moved : -0.1107/0.0001 = -1107 (down ticks)
P/L of 1 futures contract : -1107 × $12.50 (Tick value) = - $13,837.50
Daily MTM of 10 contracts = -$13,837.50 × 10 = - $138,375. Loss !

6. Forward
Page 45
FX forwards are agreements to buy one currency and sell another currency for an equivalent value
on a certain date in future. Forward rates are quoted as spreads to the FX spot rate. FX forward rate
is the exchange rate at which one currency can be exchange for another currency on a specified
future date.

For example, 3 month JPY FX forward rate quoted as -17.94 / -16.03, presenting the pre-
determined forward 3 month FX exchange rate settled at (Spot rate +-0.1794) / (Spot rate +-0.1603)
now. If the JPY Spot rate is 89.66, the 3 month forward rates will be 89.4806 / 89.4997 (= 89.66
+-0.1794 / 89.66 +-0.1603) that are Outright. When you sell/buy USD/JPY 3 month FX forward,
you will lock into the exchange rate at 89.4806 now and settled the transaction on maturity date.
When you buy/sell USD/JPY 3 month FX forward, you will lock into the exchange rate at 89.4997
now and settled the transaction on maturity, 26 Mar 2009.

Figure 45. FRD JPY<GO> displays FX forward point and Outright

Start a 3M FX Settle the 3M

Forward FX Forward

Time
Spot Date 1M 2M 3M
Spot rate Settling rate
89.66 89.4806/89.4997
but spot rate can be
anything at that time

Traders buy and sell FX forward to make money from the currency movement. For example, if a
trader sell/buy 3 month USD/JPY forward with notional USD 1,000,000 at 89.4806 on spot date
26 Dec 2008, he is looking for JPY appreciate. So, after USD/JPY drops below the agreed forward
rate 89.4806, the trader will make profit in forward market. His profit will be the JPY amount
converted from forward contract minus the JPY amount converted at prevailing spot rate at
maturity.

Page 46
Let say the spot rate reaches 86.50 as of 26 Mar 2009, the profit from FX forward is the different
between the amount of converted JPY in FX forward agreement and the amount of converted JPY
at prevailing Spot rate without forward agreement.

= (USD1,000,000 × 89.4806) – (USD1,000,000 × 86.50)

= JPY2,980,600 or USD34,457.80 ( = 2,980,000 / 86.50 ).

The tickers of FX forwards are stored in {WCV<GO>}, select Japanese Yen JPY, click into 7)
Forward exchange rate and all USD/JPY forward point tickers are available. For example, 3 month
USD/JPY FX forward points ticker is {JPY3M<Crncy>DES<Go>}.

FX forward curve

FX forward curve plots the forward points on Y-axis and tenors on the X-axis, showing the
relationship of the spreads in Spot and forward to the tenors. Positive forward points indicates
premium in forward exchange rate, and outrights are bigger than the spot rate. Whereas, negative
forward points indicates discount in forward exchange rate, and outrights are less than the spot rate.

Figure 46. USD/JPY outright and forward points in short tenors

Bid Bid
Outright USD/JPY Outright USD/JPY Point
Ask Point Ask
89.9 0.13

O/N T/N S/N 1W 2W 3W 1M

89.4 -0.37

88.9
-0.87

88.4
-1.37

87.9
O/N T/N S/N 1W 2W 3W 1M -1.87
Tenor Tenor

According to market convention, FX spot and FX forward deals are settled on the spot date, T+2.
Outright equals to spot rate plus forward point. However, when quoting T/N and O/N FX deals,
they are treated as reverting a forward deal. So, T/N outright equals to spot rate minus T/N forward
point, and O/N outright equals to spot rate minus O/N and T/N forward points.

Table 47. USD/JPY outrights and forward points data of figure 46

Point Outright Figure 46
BID ASK BID ASK BID ASK

Page 47
 O/N -0.15 0.05 89.78 - (0.05 + -0.04) = 89.77 89.99 = 89.79 - (0.05 + -0.04) -0.01 0.2
T/N -0.05 -0.04 89.78 - -0.04 = 89.82 89.84 = 89.79 - -0.05 0.04 0.05
S/N -0.16 -0.15 89.78 + -0.16 = 89.62 89.64 = 89.79 + -0.15 -0.16 -0.15
1W -0.41 -0.35 89.78 + -0.41 = 89.37 89.44 = 89.79 + -0.35 -0.41 -0.35
2W -0.83 -0.73 89.78 + -0.83 = 88.95 89.06 = 89.79 + -0.73 -0.83 -0.73
3W -1.24 -1.12 89.78 + -1.24 = 88.54 88.67 = 89.79 + -1.12 -1.24 -1.12
1M -1.85 -1.73 89.78 + -1.85 = 87.93 88.06 = 89.79 + -1.73 -1.85 -1.73

Broken date forward point

T/N, S/N, 1W, 2W, 1M, 2M, 3M, 6M, 9M, 1Y and 2Y are standard tenors, you can easily get
market quotations. Sometime when a firm wants to get a perfect hedge for their forward currency
transactions, it will like to get an odd tenor forward deal. For example, 10 days forward, that is fall
between 1W and 2W, is not a standard tenor, so broken date forward point calculation is required.
Linear interpolate between 1W and 2W is proceed in order to imply 10 days forward point, using
table 47 as an example :

Bid Ask
1W -0.41 -0.35
2W -0.83 -0.73
7 days between 1W & 2W -0.83 - -0.41= -0.42 -0.38 = -0.73 - -0.35
3 days out of 7 days -0.42 × 3/7 = -0.18 -0.16 = -0.38 × 3/7
10 days point = 1W + 3 days -0.41 + -0.18= -0.59 -0.51 = -0.35 + -0.16

The 10 days forward points are quoted at -0.59 / -0.51.

Forward forwards point

Forward forwards is a FX forward deal starting on a pre-determined future date. The Bid forward
forward point derived from Long a long tenor and Short a short tenor. In figure 45, it shows the
Forward forward points from 01/26/09 to 04/27/09 are quoted at -21.26 / -17.82. The period from
spot to 01/26/09 will be net off by one long and one short contract. On the other side, the Ask
forward forward point is also derived from Short a long tenor and Long a short tenor.

Number of days Forward point

Spot date 12/26/08 to 01/26/09 31 -5.48 / -4.98
12/26/08 to 04/27/09 122 -26.24 / -23.30
Forward forward 01/26/09 to 04/27/09 91 ?

Bid side Forward forward points from 01/26/09 to 04/27/09 :

Short forward (spot – 01/26/09)

Long forward (spot – 04/27/09)

Page 48
Net result is the forward forward Bid (01/26/09 – 04/27/09)

Short forward (spot – 01/26/09)

Offsets
Buy/Sell (01/26/09 – 04/27/09) = Buy/Sell (spot – 04/27/09) – Sell/Buy (spot – 01/26/09)
= -26.24 – -4.98 = -21.26

Ask side Forward forward points from 01/26/09 to 04/27/09 :

Long forward (spot – 01/26/09)

Short forward (spot – 04/27/09)

Net result is the forward forward Ask (01/26/09 – 04/27/09)

Long forward (spot – 01/26/09)

Offsets
Short forward (spot – 01/26/09)

Sell/Buy (01/26/09 – 04/27/09) = Sell/Buy (spot – 04/27/09) – Buy/Sell (spot – 01/26/09)

= -23.30 - -5.48 = -17.82

The forward forwards bid / ask for 01/26/09 – 04/27/09 = -21.26 / -17.82, see figure 45.

Player strategy

Corporates, which do import and export, usually need to make foreign currency payments by
deadlines. Therefore, FX forward contracts are popular hedging instruments for currency risk,
they can buy or sell contract to lock into a pre-determined exchange rate for a future settlement.
As a result, corporate can certain their future foreign payment in local value.

For example, US merchandiser has bought garments from European factory, and the EUR payment
has to complete by 3 months time when garments are delivered. The US merchandiser can lock the
exchange rate now by engaging into a FX forward contract with a banker and make payment by
the end of 3 months. As a result, further EUR appreciation will not increase the cost of payment
for the US merchandiser.

FX forward traders, who work in banks, make money by taking currency risk and act as market
makers to quote BID/ASK price for any interested counterparty. When they expect EUR
depreciates, they will take the short forward contract with US merchandiser and try to make money.
If they have the same view as merchandiser, they will unwind the short forward position to the
market.

FXFA calculation

Figure 48. FXFA<GO> indicates FX – Forward rate arbitrage

Page 49
Interest rate parity (IRP) concept is the basic idea to imply the interest rate of foreign currency.
Since USD has the most liquid interest rate market, banks can easier borrow and lend USD through
inter-bank market. Therefore, USD money market rate, spot rate and FX forward point are the
essential material to imply foreign money market rate.

EUR/USD spot rate = 1.3470 / 1.3478

1Month EUR/USD forward

1 Month EUR forward implied interest rate Bid :
USD 1 lending = $1× (1+ 0.45% × 31/360)
EUR (equivalent to USD 1) borrowing = $1/1.3470×(1+ rbid% ×31/360) ×(1.3470+-1.79/10000),
that is buy USD sell EUR in spot market and borrow EUR then buy EUR in forward market.
According to IRP, Set USD lending = EUR borrowing to solve the 1 Month EUR BID rate, rbid% :
rbid% = {(1+0.45%× 31/360) ×1.3470/[(1.3470+-1.79/10000)]-1}× 360/31
= 0.006044 = 0.6044%

Please note! Only BID spot rate, 1.3470, is used, as only one spot rate is fixed in 1 forward contract.
Since Forward points are quoted by banks, calculations are favour to banks.

1 Month EUR forward implied interest rate Ask :

USD 1 borrowing = $1× (1+ 0.65% × 31/360)
EUR (equivalent to USD 1) lending = $1/1.3478×(1+ rask% ×31/360) ×(1.3478+-2.14/10000), that
is sell USD buy EUR in spot market then lend out and convert back to USD in forward market.
Set USD return = EUR return to solve the 1 Month EUR ASK rate, rask% :
rask% = {(1+0.65%× 31/360) ×1.3478/[(1.3478+-2.14/10000)]-1}× 360/31
= 0.008345 = 0.8345%, see figure 48.
O/N EUR/USD forward

O/N EUR forward implied interest rate Bid :

USD 1 lending = $1× (1+ 0.33% × 1/360)

Page 50
EUR (equivalent to USD 1) borrowing
= $1/[1.3470- (-0.37+ -0.12)]×(1+ rbid% ×1/360) ×[1.3470- (-1.79/10000)]
that is buy USD sell EUR on today (T) and borrow EUR then buy EUR in forward market valid
on the next business day (T+1).
According to IRP, Set USD lending = EUR borrowing to solve the O/N EUR BID rate, rbid% :
rbid% = {(1+0.33%× 1/360) ×[1.3470- (-0.37+-0.12)/10000]/[1.3470-(-0.37/10000)]-1}× 360/1
= 0.006507 = 0.6507%

O/N EUR forward implied interest rate Ask :

USD 1 borrowing = $1× (1+ 0.58% × 1/360)
EUR (equivalent to USD 1) lending
= $1/[1.3478- (-0.56+-0.17)]×(1+ rask% ×1/360) ×(1.3478- -0.56/10000)
that is sell USD buy EUR on today (T) then lend out and convert back to USD in forward market
valid on the next business day (T+1).
Set USD lending = EUR borrow to solve the O/N EUR ASK rate, rask% :
rask% = {(1+0.58%× 1/360) ×[1.3478- (-0.56+-0.17)/10000]/[(1.3478-(-0.56/10000)]-1}× 360/1
= 0.010341 = 1.0341%, see figure 48.

Short term tenors, from O/N to 1 year, use day count Actual/360 as Money market. All tenors over
1 year use day count 30/360 following interest rate swap.

USD Semi-annual & EUR Annual.

2 Year EUR/USD forward

2 Year EUR forward point Bid :

Number of days from 03/20/09 – 03/21/11
= (03/20-09-03/31/09) + (23×30) + (03/01/11-03/21/11) = 11 + 690 + 20 = 721 days
USD 1 lending = $1× (1+ 1.45%/2 )[721/(360/2)]
EUR (equivalent to USD 1) borrowing = $1/1.3470×(1+ 1.287% ) (721/360) ×(1.3470+ Fbid /10000)
Set USD lending = EUR borrowing to solve the 2 Year EUR BID point, Fbid :
Fbid = {[(1+1.45%/2)[721/(360/2)] ×1.3470/(1+1.287%)(721/360) ]-1.3470}×10000
= 44.85175

2 Year EUR forward point Ask :

USD 1 borrowing = $1× (1+ 1.45% )[721/(360/2)]
EUR (equivalent to USD 1) lending = $1/1.3478×(1+ 1.2217% ) (721/360) ×(1.3478+ Fask /10000)
Set USD borrowing = EUR lending to solve the 2 Year EUR ASK point, Fask :
Fask = {[(1+1.45%/2)[721/(360/2)] ×1.3478/(1+ 1.2217%) (721/360) ]-1.3478}×10000
= 62.35599, see figure 48.

FX portfolio

To input FX forward deal and create ticket in Bloomberg, you need to use {OVML<GO>}. In
OVML, set ‘STYLE = CASH’ for currency deposit and ‘STYLE = FX HEDGE’ for FX spot and

Page 51
forward deals, then press top red ‘TOOLS/OPTIONS’ button and select ‘ADD TO PORTFOLIO’
to save your deal under a chosen portfolio. After all, you can open your portfolio in {PRTU<GO>}
to confirm deal saved. Run {OVRA<GO>} on portfolio to get performance and risk analysis.

Figure 49. EUR<Curncy>OVML<GO> → set Style = FX Hedge

This ticket is input according to the 1year FX forward in figure 48.

FX Forward Arbitrage

{FXIA<GO>} is used to locate arbitrage opportunities between countries. {FXIA<GO>} allows

us to find the lowest borrowing costs and/or the highest lending rate opportunities. This FX Interest
Rate Arbitrage Screen allow us to enter the appropriate data to calculate and to locate arbitrage
opportunities, that achieves by borrowing foreign currency rate at lower cost or lending feign
currency rate at higher level via FX forward market.

The Base Currency normally is USD. It will be the currency against which the other currencies are
measured. In figure 49, the value date 05/08/09, that is 2 business day after the trading day, the
date on which arbitrage rates are valued. The swap period is 1 month, which is the time frame for
borrowing. The maturity date is 6/8/09, when the principal amount becomes due and payable. The
number of calendar days to this deal between the value date and the maturity Date is 31 days.

FXIA calculates the Lending rate of USD/EUR and several foreign currencies by using FX forward
instrument from a value Date of 5/8/09 to a maturity of 6/8/09.

USD is shown in the first row, as it is the base currency. The 1 month US Libor rate {US0001M
<CRNCY>DES<GO>} is represented as the deposit rate 0.40125%, with day count Act/360.

According to Interest Rate Parity, identical returns should be obtained under the same risk exposure.
Therefore, the return of USD in 31 days should also be equal to USD converted to Euro using spot,
gaining Euro interest rate, then converted back to USD via the forward market.

Page 52
Figure 50. FXIA<GO>

{FXIA<GO>} to calculate the implied money rate from FX forward market from 05/08/09 to
06/08/09 :

USD return in 31 days = USD 1 × [1+ ( 1M USD Libor × 31 days/360) ]

= 1 × [1+( rUSD% × 31/360)], where r% is the deposit rate for USD.

The EUR return in 31 days = Spot rate × [ 1+ ( REUR%× 31/360)]

= 0.75446×[ 1+ ( 0.9025% ×31/360)]
The Euro return converted into USD using the forward contract at the outright rate
= 0.75446×[ 1+ ( 0.9025% ×31/360)] /0.75451

According to Interest Rate Parity, identical returns should be obtained under the same risk exposure.
Therefore, the return of USD in 31 days should also be equal to USD converted to Euro using spot,
gaining Euro interest rate, then converted back to USD via the forward market.

Therefore, 1×[1+( rUSD%×31/360)] = 0.75446×[1+( 0.90250%×31/360)] /0.75451,

rUSD% = [(0.75446×(1+0.90250%×31/360)/0.75451)-1]×360/31
= 0.825484%

0.825484%= the arbitrary rate shown on row 2 for EUR in figure 50. Decimal differences are due
to rounding in Spot, Outright and interest rate in {FXIA<GO>}.

The arbitrage opportunity is to borrow USD at 0.40125% and lend out EUR via Forward market
at 0.90125%, that is equivalent to lending USD at 0.82402%. As a result, interest rate differential
0.42277% (=0.82402% - 0.40125%) of USD can be created.

Arbitrage Rates for other currencies can be calculated by the same method. The arbitrage rate
highlighted in red indicates that is the HIGHEST lending rate via Forward market. Therefore, the
biggest Arbitrage opportunity is to borrow US Libor at 0.40125% and lend out DKK at 2.3883%
for 1 month via Forward market. That is equivalent to lending USD at 1.40596%.

Page 53
In {FXFA<GO>} shown in figure 48, when Implied EUR deposit Bid rate is greater than the depo
market Bid rate, a green value will show in the Spread Bid column. So, lending out EUR via
forward market will give you higher interests than deposit to depo market. Whereas, when Implied
EUR deposit Ask is smaller than the depo market Ask rate, a red value will show in the Spead Ask
column. Therefore, you should borrow EUR from depo market as that is cheaper than borrow EUR
via forward market.

HOW to input Arbitrage FX deal in OVML ?

Arbitrage steps :
1. Borrow USD 1mio at 1.25%
2. Exchange USD to CNY at 6.8264 spot rate
3. Deposit CNY 1month at 2.25%
4. Then convert that back to USD at 6.7772 forward rate.

FX rate IR Days Interest P+I

USD 1,000,000 1.25% 30 1,041.67 1,001,041.67

CNY 6,826,400 6.8264 2.25% 12,624.16 6,839,024.16

Back to USD 6,839,024.16 6.7772 1,009,122.38

Profit/Loss 8,080.71

P/L number can be obtained in OVRA, see figure 53.

1. For Borrow USD 1mio

First calculate the Principal + interest amount = 1,000,000x(1+(1.25%x30/360)) = 1,001,041.67

Style = Cash
Direction = Receive
Value = USD
Notional = USD
USD Depo = 2.25%
Page 54
Maturity = 1Month
Notional = Principal + Interest
Press ACTIONS → ADD to Portfolio → set Premium = 0

Figure 51. CNY<Crncy>OVML CASH<GO>

2. No need to input spot deal

3. CNY deposit

Calculate the Principal + interest = 6,826,400x(1+(2.25%x30/365)) = 6,839,024.16

Style = Cash
Direction = Pay
Value = CNY
Notional = CNY
CNY Depo = 2.25%
Maturity = 1Month
Notional = Principal + Interest
Press ACTIONS → ADD to Portfolio → set Premium = 0

Page 55
 4. FX forward Sell CNY Buy USD

Style = FX Hedge
Direction = Sell
Value = USD
Rate = 6.7772
Notional = CNY
Notional = Principal + Interest
Maturity = 1Month
Press ACTIONS → ADD to Portfolio → set Premium = 0

Figure 52. CNY<Crncy>OVML FX<GO>

Page 56
  See Negative Value when you receive (or gain) money
 Positive Value indicates you pay (or lose) money

Then run OVRA<GO> for FX P/L analysis, the P/L is on the P/L HOME currency and P/L Ccy
1 columns.

Figure 53. P/L in OVRA<GO>

If Cash deals and FX hedge deal are saved with Premium, the P/L will appear in Value
Ccy1, that is not correct.

7. NDF

NDF is Non-deliverable forward, that is also FX forward transaction by for restricted currencies
only. Restricted currency, which has tight capital control, is not possible to settle large amount in
outside the domestic countries. In order to hedge the currency risk or speculate in its exchange
value, NDF is the financial instrument to get involve to the currency market without any settlement
problem. Therefore, NDF trades outside the home country, that is known as offshore transaction.

NDF is a contract of foreign exchange deal, between a NDF currency and a major currency, settled
in an agreed future date but the exchange rate is pre-determined on the trade date with counterparty.
At maturity, since the actual NDF currency is not delivered, the whole transaction will be settled
in a major currency (usually USD in America and Asia or EUR in Eastern Europe). The amount of
settlement is the profit and loss of the transaction that is calculated by the different of the pre-
determined exchange rate to current spot rate. 2 business days before the maturity date is normally
the fixing date of the NDF exchange rate, and the daily fixed spot rate given by authority will be
agreed as the current spot rate used to calculate the profit and loss of the whole transaction. The
loser needs to pay the net balance to the counterparty in order to complete the deal, without
principal movement.

NDF fixing
Page 57
NDF fixings are released daily for central banks or authority bodies, that is used to compare to the
contract rate in order to calculate P/L in NDF deal.

APFX<GO> for Asian NDF fixing

NDFL<GO> for American NDF fixing
CFXN<GO> for all currency fixing

Figure 54. APFX<GO> Asian NDF fixing

Player strategy

Today 20 July, NDF quotation from a bank :

Currency = KRW
Spot rate = 940.30
Value date = 22 July
Tenor Maturity dates Forward rate
Points Outright = Spot + Points
1W 29 July -0.25 940.05
1M 22 Aug -1.65 938.65
2M 22 Sep -2.95 937.35

Otto Company had imported Korean cars to US and needed to pay KRW 10 million by 1 month,
but they worried about strengthening in the value of KRW at that moment.

So Otto Company decided to have a 1 month NDF contract with the bank and agreed to buy KRW
10 million at 938.65 against USD on 22 Aug.

On fixing date 21 Aug, USD/KRW is fixed at 944.60 shown in figure 54.

The profit and loss amount will be settled on maturity :

Page 58
 Otto agreed to pay in USD,
10,000,000 / 938.65 = USD 10,653.60
The USD amount should be paid by using the current fixing rate,
10,000,000 / 944.60 = USD 10,586.49

By comparing the agreed payment to the benchmark, the different is

USD 10,586.49 – USD 10,653.60 = -USD 67.11. Loss !

Since KRW had depreciated against USD and Otto Company had agreed to pay a larger amount in
USD, it made a loss of USD 67.11 in this NDF contract. If Otto Company were never have this
NDF deal, it would be paying USD 10,586.49 for KRW 10 million by using current spot rate
instead of paying USD 10,653.60. Finally, Otto Company needs to pay USD67.11 to the bank in
order to settle the NDF contract.

NDF calcuation :

On the value date : D = N / spot …………..…equation (1)

D = Major currency
N = NDF currency
Spot = Foreign exchange rate

At maturity : According to the rule of Interest Rate Parity

D x ( 1 + rd ) × Outright = N × ( 1 + rn )

Outright = N × ( 1 + rn ) = N × ( 1 + rn )
D × ( 1 + rd ) (N/spot) ×( 1 + rd ) ....from equation (1)

Outright = ( 1 + rn )
Spot ( 1 + rd )

( 1 + rn ) = Outright × ( 1 + rd )
spot

The implied interest rate of NDF currency ( rn ):

Outright
〔
rn =
Spot
× ( 1 + rd )
〕 -1 .... equation (2)

Comparing the implied interest rate of in NDF to the domestic deposit rate, there is a huge spread.
This discrepancy between the offshore and onshore markets is because no arbitrage trade is allowed
for the non-deliverable currency or nobody has access to correct the market. NDF is highly
restricted.

Since implied interest rate in NDF market can’t be achieved in real deposit market, that is just a
reference rate. Negative Implied interest rate can appear.
Figure 55. NDF<GO> → USD/CNY NDF market

Page 59
Figure 55 shows that CNY had negative implied interest rate in Mar 2008. When foreign traders
expected CNY should have a quick appreciation versus USD but that had not been happening yet,
the NDF market would trigger negative interest rate in order to balance out the exchange rate profit.
So, NDF trader, who has bought CNY and enjoyed currency return, shall pay interests to the short
CNY counterparty in order to net off the currency return; as there is no real CNY appreciation in
2008.

Equation 2 :

The implied interest rate of NDF currency ( rn ):

Outright
rn = 〔 Spot
× ( 1 + rd )
〕 -1 .... equation (2)

1Month CNY implied deposit Bid rate :

rCNY Bid = {[ (7.08 -0.123)/7.08× (1+ 2.5356% ×32/360)] -1} ×360/32
= -0.1705294 = -17.05%

1 Month CNY implied deposit Ask rate :

rCNY Ask = {[ (7.08 -0.118)/7.08× (1+ 2.5356% ×32/360)] -1} ×360/32
= -0.1625666 = -16.25%

8. FX Swap
Page 60
There are several types of currency swap contracts, but the most widely used in recent years is FX
swap. A typical FX swap agreement is a contract in which an European bank borrows USD and
lends EUR to a US bank simultaneously. At start of contract, European bank borrows X amount of
USD and lend EUR (X amount / S) to US Bank, where foreign exchange rate, S , is the prevailing
spot price. When the contract expires, European Bank returns X amount of USD to US Bank, and
the US Bank returns EUR ( X /F ) to European Bank that F is the FX forward rate as of the start of
contract.

In order words, European Bank and US Bank borrow foreign currency by putting their home
currencies as collateral, so the counterparty risk is reduced effectively. As a result, most of these
transactions are long term, ranging from 1 year to 30 years, with extremely large settlement amount.

European Bank Cash Flows

Borrow Return USD X
USD X + USD interest

Time
1Y

Spot Date 2Y
Spot rate Receive ( USD X × 1.339 )
1.339 + EUR interest
Lend out EUR F = Total USD/Total EUR
X / 1.339 but spot rate can be anything at
that time

Figure 56. FX Swap cash flow

Page 61
 At the beginning of transaction

EUR 7,421,701
European Bank US Bank
USD 10,000,000

Accumulate USD interest NO Swap transaction Accumulate EUR interest

rate at fixed semi-annualized rate at fixed annualized
rate, e.g. 1.45% for 2 years. rate, e.g. 1.19021% per
annual for 2 years.

By the end of transaction

EUR 7,421,701 + 1.19021% interest in 2years

Japanese Bank US Bank

USD 10,000,000 + 1.45% interest in 2years

USD 10,000,000 + 1.45% interest in 2years

EUR/USD 2Y Outright =
EUR 7,421,701 + 1.19021% interest in 2years

The tickers of FX swap are the same as FX forward points tickers, as they are traded in the same
FX forward markets. For example, 5 year USD/JPY FX swap points ticker is
{JPY5Y<Crncy>DES<Go>}.

The different between FX forward and FX swap is the number of exchange transaction take place.
FX forward has only one transaction, that is at maturity. Whereas, FX Swap has 2 transactions,
that are at the beginning and the maturity.

FX swap in SWPM

Page 62
To construct a FX swap in {SWPM<GO>}, Zero Coupon and Fixed Coupon are required for both
legs. Zero Coupon is set so that the coupon interests will be accrued until the end, and the principal
plus interests will be exchanged on the maturity date. In figure 57, EUR/USD FX swap has the
same calculation as FXFA 2 Year in Figure 48. The reason for some deviation in EUR interest rate
is the different forward curves are used.

Figure 57. SWPM -FXFX<GO> → EUR/USD FX Swap

FX swap in OVML

To input FX swap deal into {OVML<GO>}, you need to input one FX Spot deal for the notional
amount exchanged at the beginning of the swap by setting Style = FX Hedge. Together with other
FX forward deal for the notional amount exchanged on maturity date of the swap by setting Style
= FX Hedge. After all, 2 legs FX Hedge deal can be analyzed in the Option Valuation Risk Analysis
{OVRA<GO>}.

Figure 58. EUR<Crncy> OVML<GO> → 2 Year EUR/USD FX forward deal

Page 63
Figure 59. OVRA<GO> → analysis of FX spot and FX forward deals

In {OVRA<GO>}, there are 2 records, one is FX forward deal and the other is a FX spot of
EUR/USD 1 million. You can read the P/L in USD, fixed forward rate and current forward rate in
the table.

Player strategy

Some traders buy/sell EUR/USD when they need EUR on spot date, in order to solve the short
term money shortage in EUR position. As USD is the most liquid currency in money market and
widely used in FX market, traders can access USD funding easily comparing to EUR. Therefore,
FX forward points are always used to imply the interest rate level of money market. However, the
traders need to return the principal plus interest of EUR to the counterparties and receive the USD
at maturity simultaneously. If the traders have persistent short EUR position after paying back
principal, they will create another new EUR/USD FX swap to get short term funding again.

9. Cross currency Basis swap

Page 64
A Cross currency basis swap is a FX swap, but the main different is that there are floating interest
rates for both currencies. A typical cross currency Basis swap agreement is a contract in which
Japanese banks borrow X amount US dollars (USD) and lend (X amount × S) JPY to US bank
simultaneously at the beginning, which foreign exchange rate ,S, is the prevailing spot price.
During the contract term, the Japanese Bank receives JPY 3M Libor + and pays USD 3M Libor
to US Bank every 3 months. is the price of the basis swap determined by both banks, expressed
in basis point. On expiry day, Japanese Bank returns X amount of USD to US Bank, and the US
Bank returns XS amount of JPY to Japanese Bank.

In order words, Japanese Bank and US Bank borrow foreign currency by putting their home
currencies as collateral, so the counterparty risk is reduced effectively. As a result, most of these
transactions are long term, ranging from 1 year to 30 years. However, basis swap is not as popular
as FX swap deal and the settlement amounts are not large, because it does not only consist of
currency risk but also interest rate risk in both currencies.

Japanese Bank Cash Flows

Borrow USD X + USD 3M
USD X USD 3M Libor Libor interest
USD 3M Libor USD 3M Libor
interest
interest interest

Time
3M 6M 9M
JPY 3M Libor
interest + JPY 3M Libor
JPY 3M Libor
Spot Date interest +
interest + 5Y
Spot rate = 89.66 JPY X × 89.66 + JPY interest
Lend out JPY X but spot rate can be anything at that
× 89.66 time

Figure 60. Basis swap cash flow

Page 65
 At the beginning of transaction

JPY 965,100,000
Japanese Bank US Bank

USD 10,000,000

Swap transaction

Paying USD interest rate Paying JPY interest rate at

at 3 month Libor every 3 month Libor + basis
quarter points every quarter

By the end of transaction

JPY 965,100,000 + interest (3M Libor + )

Japanese Bank US Bank

USD 10,000,000 + 3M Libor interest

The tickers are stored in {WCV<GO>}, select a currency e.g. JPY, select 26) Basis swap. For
example 5 year USD/JPY Libor Basis swap ticker is {JYBS5<Crncy>DES<GO>}.

Figure 61. JYBS<Crncy>ALLQ<GO>

Page 66
Basis swap in SWPM

Figure 62. SWPM -FLFL<GO> → 5 Year USD/JPY Basis swap

In Figure 61, the price of the basis swap is quoted at 17.00 / 21.00 in the market. In Figure 62,
SWPM calculate the basis spread for 5 year USD/JPY Basis Swap is 21.32, that is added on top of
the JPY Libor fixing in order to get the coupon interest. The first JPY Coupon interest is 0.91625%
+ 0.2132% = 1.12945% paid on 02 Jul 2008, and it will be JPY Libor + 0.2132% after all. The
USD Coupon interest is according to USD Libor.

Player strategy

Traders, who buy/sell USD/JPY basis swap, are looking for JPY interest rate will rise faster than
USD interest rate. So, the JPY interest amount they receive will increase as the central bank raise
interest rate. Traders will have both USD and JPY interest rate risk exposures. On the other hand,
if the JPY appreciates, Japanese Bank will earn extra profit. As the amount of JPY they receive on
maturity is more than the conversion amount from prevailing spot rate. When JPY appreciates,
USD 10 million can buy less than JPY 965.1 million. As a result, currency risk exposure is involved
too.

Page 67
10. Cross currency swap

A Cross currency swap, CCS, is also a FX swap, but the main different is that there are fixed rate
for one currency and a floating interest rates for other currency. A typical cross currency swap
(CCS) agreement is a contract in which Japanese banks borrow X amount US dollars (USD) and
lend (X amount × S) JPY to US bank simultaneously at the beginning, which foreign exchange rate,
S, is the prevailing spot price. During the contract term, the Japanese Bank receives JPY annual
fixed rate and pays USD 3M Libor to US Bank, that annual fixed rate is the price of the Cross
currency swap determined by both banks. On expiry day, Japanese Bank returns X amount of USD
to US Bank, and the US Bank returns XS amount of JPY to Japanese Bank.

In order words, Japanese Bank and US Bank borrow foreign currency by putting their home
currencies as collateral, so the counterparty risk is reduced effectively. As a result, most of these
transactions are long term, ranging from 1 year to 30 years.

However, CCS is a very common investment and hedging instrument for non-deliverable
currencies, as traders do not want to take interest rate risk of NDF currency but they are more
willing to handle USD or EUR interest rate risk. Major currencies have plenty hedging instruments
available in the market. Most of the CCS is custom agreement, counterparties can negotiate any
term and condition. The above description is just an example.

Japanese Bank Cash Flows

Borrow USD X + USD 3M
USD X USD 3M Libor Libor interest
USD 3M Libor
interest USD 3M Libor
interest
interest

Time
3M 6M 9M
JPY fixed JPY 1.00332% JPY 1.00332%
interest interest interest
Spot Date 5Y
Spot rate = 96.51 JPY X × 96.51 + JPY fixed interest
Lend out JPY X at 1.00332%
× 96.51 but spot rate can be anything at that time

Page 68
Figure 63. Cash flow chart of Cross currency swap

At the beginning of transaction

JPY 965,100,000
Japanese Bank US Bank

USD 10,000,000

Swap transaction

Paying USD interest rate Paying JPY interest rate at

at 3 month Libor every fixed rate 1.00332% every
quarter year

By the end of transaction

JPY 965,100,000 + interest at 1.00332%

Japanese Bank US Bank

USD 10,000,000 + 3M Libor interest

Cross currency swap in SWPM

Figure 64. SWPM<GO> → JPY/USD Cross currency swap.

Page 69
Japanese Bank receives 1.00332% annual fixed rate (Act/365) on notional JPY 965,100,000 and
pays 3 Month Libor (Act/360) on notional USD 10 million for 5 years. The FX rate is 96.51 and
that determined by 2 counterparties at the beginning.

Figure 65. Japanese Bank delivers the JPY 965.1 million then receives the same amount on
maturity.

The JPY interest payment on 24 Nov 2009 :

Number of day from 21 Nov 08 to 24 Nov 09 = 368 days
= JPY 965,100,000 × 1.003315369% × 368 / 365
= JPY 9,762,582.90

The JPY interest payment on 22 Nov 2010 :

Number of day from 24 Nov 09 to 22 Nov 10 = 363 days
= JPY 965,100,000 × 1.003315369% × 363 / 365
= JPY 9,629,939.11

Figure 66. Japanese Bank receives USD 10 million then returns the same USD amount on maturity.

The USD interest payment on 23 Feb 2009 :

USD 3 Month Libor fixing on 19 Nov 08 = 2.21750%
Number of day from 21 Nov 08 to 23 Feb 09 = 94 days
= USD 10,000,000 × 2.21750% × 94 / 360
= 57,901.39

Figure 67. To find the Cross currency tickers, type USD JPY SWAP in WCV<GO> and search

Page 70
The 5 year USD/JPY Cross currency swap ticker is {JYUSSW5 <Crncy>}. Go into {DES<GO>}
page 2 to see the market convention detail. Market price of 5 year USD/JPY Cross currency swap
is 1.0174%, and SWPM calculates 1.00332%.

Player strategy

Both Japanese Bank and US Bank are exploring to Interest rate risk and currency risk. Japanese
will make a better payoff when the US interest rate declines and JPY appreciates. Since the US
loan rate is floating, Japanese will pay less US interest after rate cut. In addition, regarding to the
currency risk, Japanese should receive more amount of JPY equivalent to USD 10 million if JPY
depreciates, but they receive the same amount as of beginning.

11. NDS

Non-deliverable swap NDS, which is similar to a cross currency swap, evaluating the interest rate
differential between a capital-controlled country to a major country but settled in a major currency
especially USD and EUR. The swap involves in a fixed interest rate in non-deliverable currency
in exchange for a floating rate in a major currency, without principal exchange at the beginning.

If 2 companies enter into a currency swap for U$1 million and one company is located in a country
with a restricted currency, it would mean that payments due to the company in the restricted
currency is converted into the major currency at the prevailing spot rate on each interest payment
and at maturity. The principal appreciated amount is the profit and loss in Notional.

Figure 68. SWPM -NDS<GO>

Page 71
Player strategy

Foreign companies operating emerging market business will like to lock into a fixed interest rate
loan agreement to certain the amount of expense. They will engage to a NDS deal to transfer the
interest rate risk from emerging market to major currency market, as there are plenty of hedging
instruments available in major currency market. For example, a foreign company has borrowed a
loan for its business in emerging country, it will transfer the emerging market interest rate risk into
USD interest rate risk. Movement of interest rate in emerging market can be extremely large due
to political and economic instabilities.

Long CNY NDS Cash Flows

CNY performance in USD +
USD 6M Libor USD 6M Libor interest
interest USD 6M Libor
interest USD 6M Libor
interest

Time
6M 1Y 18M
CNY fixed CNY 4.98973% CNY 4.98973%
interest in USD interest in USD interest in USD
Spot Date 5Y
Spot rate = 6.83805 (CNY performance + CNY fixed
interest at 4.98973%) in USD
but spot rate can be anything at that time

Figure 69. Long CNY NDS cash flows

Page 72
 At the beginning of transaction

Bank A No exchange Bank B

Swap transaction

Paying USD interest rate Paying CNY interest rate at

at 6 month Libor fixed rate 4.98973% semi-
annually that is converted
into USD at spot rate on
each payment date

By the end of transaction

Bank A Principal P/L in USD Bank B

NDS in SWPM

It is a 5 year USD/CNY NDS swap, trader agrees to receive CNY at fixed rate 4.98973% semi-
annually and pays USD 6 month Libor for 5 years without principal exchange.

Figure 70. SWMP CNY –NDS<GO>

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For Non-deliverable currency, Cross currency swap tickers can be retrieved in {WCV<GO>},
select a NDF currency, and those are stored in Non-Deliverable (NDS) Swaps item. The tickers
are stored in {WCV<GO>} under Non-Deliverable (NDS) Swaps. For the above 5 year USD/CNY
NDS swap, the ticker is {CCSWN5<Crncy>DES<Go>}. The market quotes 5.05% and SWPM
calculates 4.98973%.

Figure 71. WCV<GO> → CNY → 22) Non-Deliverable (NDS) Swaps

Page 74
12. NDIRS

Basically, NDIRS is an interest rate swap in highly restricted currency. Two foreign banks
exchange fixed interest payment with floating interest payment of non-deliverable currency but
settle in term of major currency over an agreed period, so only the net amounts or profit/loss are
settled in currency major USD or EUR. No NDF currency settlement is involved. The swap
involves in a fixed interest rate in exchange for a floating rate of a non-deliverable currency,
without principal exchange at beginning and maturity.

If 2 banks, which are both located in developed countries, enter into a CNY10 million IRS swap,
that both banks are unable to settle this deal in CNY currency. Therefore, they will convert net
interests into the major currency at the prevailing spot rate on each interest payment and at maturity.

Player strategy

When a foreign traders want to get into interest rate risk exposure in those non-deliverable
currencies, such as CNY, PHP, INR, IDR and KRW, but find difficulty in get large amount of
those currency to settle, they will start an NDIRS in order to make money in the interest rate market
without any currency risk. The advantage of NDIRS, it allows multi-national companies to cover
the interest rate risk for their business established in those restricted countries and convert these
payments in major currency.

If a US retailer borrow CNY loan in China but afraid that the interest rate hide will hurt its profit
margin, the US head office will hedge CNY interest rate risk by engaging into a NDIRS with a US
banker. Paying fixed CNY interest rate allows retailer to lock interest expenses, and receiving CNY
floating let him to earn higher interests if CNY rate hides. As a result, the retailer receives the profit
and loss, in term of USD, of the net amount CNY floating and CNY fixed rate.

Short CNY NDIRS Cash Flows

Accrued CNY Accrued CNY Accrued CNY 7 days

7days interest Accrued CNY
7days interest 7days interest interest in USD
in USD in USD in USD

Time
3M 6M 9M
CNY fixed CNY 3.33% CNY 3.33%
interest in USD interest in USD interest in USD 5Y
Spot Date CNY fixed interest at
3.33% in USD
but spot rate can be anything
at that time

Figure 72. CNY NDIRS cash flow

Page 75
 At the beginning of transaction

Bank A No exchange Bank B

Swap transaction

Paying CNY fixed interest Paying CNY the accrued 7

rate at 3.33% quarterly, day Repo rate quarterly,
that is converted into USD that is converted into USD
at spot rate on each at spot rate on each
payment date payment date

By the end of transaction

Bank A Net interests in USD Bank B

NDIRS in SWPM

Figure 73. SWPM CNY -NDIRS<GO>

Page 76
It is a 5 year USD/CNY NDIRS, trader agrees to pay or receive the net amount of ( +CNY fixed
rate at 3.33% quarterly – CNY 7 days repo rate ) in USD every quarter until maturity. No principal
exchanges at beginning or maturity.

The tickers are stored in {WCV<GO>} under Non-Deliverable (NDS) Swaps. For the above 5 year
USD/CNY NDIRS swap, the ticker is {CCSWNI5<Crncy>DES<Go>}. SWPM calculates the
fixed rate 3.33%, and the market quotes 3.330% / 3.35% in figure 74.

Figure 74. CCSWNI5<Crncy>ALLQ<GO>

Page 77
13. Power Reverse Dual Currency Note (PRDC)

PRDC is a principal-protected note that pays a high initial coupon ranging from 4% - 7% and then
the subsequent coupon is lined to an exchange rate. Most of PRDC in market are also callable with
Bermudan option dates, and the coupons are usually floored at zero. Bermudan option has a series
of exercise dates.

PRDC is popular in Japan and payments are in JPY dominated. It has been offered investor looking
for high yield in a prolonged low rate environment, the payments rise if the JPY depreciates. The
coupon is larger if USD/JPY is higher on the coupon date, and the coupon is smaller if USD/JPY
is lower on that date. Therefore, it is also used extensively in the carry trade where banks and large
coupon of a PRDC structure is fixed and subsequent coupons are then proportional to a FX rate
(domestic currency per one unit of foreign currency). On the other hand, issuer is effectively short
FX options with strike lower down in FX.
Japanese investors who buy PRDC want to earn higher yields available in other currencies without
baring the currency risk, and the issuers in high interest rate countries who want to borrow at low
cost without taking currency risk.

Figure 75. SWPM → Structure note → PRDC

In figure 75, a JPY 10 million notion PRDC is sold at JPY 10,721,233.34, paying first coupon rate
at 5%, coupon = MAX [USD 7% × (FXn / FXo) – JPY 4%, 0%]. Japanese investors is paying
JPY10,721,233.34 to get into PRDC and receive JPY coupon in a range of 4% to 7%.

where FXo = Original FX rate on the spot date

FXn = FX rate of Coupon fixing

PRDC has advantage of 100% principal guaranteed, enlarge the coupon income under a low
interest rate environment.

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14. Dual Currency Deposit (DCD) or Currency Linked Note (CLN)

A dual currency deposit is a derivative instrument which combines a money market deposit with a
currency option to provide a higher yield than that available for a standard deposit. There is a higher
risk involved, as you can receive fewer funds than originally deposited and in a different currency
at maturity. For example, you could do a USD/JPY DCD depositing USD then receiving JPY.

DCD is a fixed deposit with variable terms for the currency of payment. Deposits are made in one
currency, but withdrawals at maturity occur either in the currency of the initial deposit or in another
agreed upon currency. This is a deposit that creates a foreign exchange rate risk for the investor.

DCD will be available in {OVML<GO>} → 93: Structure Note → Dual Currency Deposit (DCD)
in near future.

DCD Calculation

What interest rate can Bank A offers you a USD/JPY 3Month DCD, with strike 106, per annual,
when the 3Month deposit of USD and JPY are 2.728% and 0.827% respectively ?

DCD is a combination of a deposit and selling a PUT option.

So first of all, Bank A need to price a PUT USD/JPY 3Month vanilla option.

Figure 76. JPY <Crncy>OVML<Go>

Figure 76 is a Put JPY and Call USD with notional USD 1 million at FX rate 106.00. The option
buyer will have the right to sell JPY at 106.00 if the USD/JPY below that level, so buyer will pay
JPY 106 million (=106.00 × US$ 1 million) and receive US$ 1 million when exercising the option.
Alternatively, the option writer will have the obligation to buy JPY at 106.00 if the USD/JPY below

Page 79
that level, so writer will receive JPY 106 million and paying US$ 1 million when the option is
exercised.

This Put JPY Call USD option price is quoted at US$13,186/US$13,695, so the writer sells it at
US$13,186. The Bid price is used because the writers are the note investors, so it is a buying Put
JPY option from a bank point of view.

Although this option is sold at the inception, this premium may be paid out in the form of deposit
interest at maturity if the option is not exercised. Premium is kept till maturity by the bank.

3Month USD money market deposit at 2.728% :

Number of day from 16 May 2008 to 18 Aug 2008 = 94 days
Interest = US$ 1,000,000 × 2.728% × 94 / 360
= US$ 7,123.11
Money market convention (Actual / 360)

Quotation of 3Month USD/JPY DCD deposit rate :

Principle + interest + option price = U$ 1 million + U$ 7,123.11 + U$ 13,186.00
= U$ 1,020,309.11

The annualized rate = [U$(1,020,309.11-1,000,000) / U$ 1,000,000] × (360 / 94) × 100%

= 7.777957%

Bank A will offer a 3Month USD/JPY Dual Currency Deposit at 7.777957% per annual.

Player strategy

Investor expects the FX market will be stable and has very low volatility, so he will enjoy maximize
the interest earning by receiving Put option premium. Nonetheless, if JPY appreciates and
USD/JPY falls down substantially, investor will not have any benefit from JPY appreciation. Profit
is capped. Whereas, when JPY depreciates and USD/JPY jumps over 110, investor needs to
purchase JPY at 106 that is more expensive than the prevailing market rate.

Payoff

Scenario 1:

If JPY appreciates and USD/JPY spot rate settles below 106.00, to 104.50, on maturity, the PUT
option will not be exercised. The DCD investor will receive Principle, deposit interest and option
premium eventually. As a result, his 3Month investment will have a return as high as 7.777957%.

Total return :
US$ 1,000,000 × [1 + (7.777957% × 94 / 360)] = US$ 1,020,309.11

Scenario 2:

Page 80
If JPY depreciates and USD/JPY FX rate settles above 106.00, to 108.65, on maturity, the PUT
option will be exercised and writer will have obligation to purchase JPY at 106.00 eventually. The
DCD investor will receive JPY 106,000,000 (= US$1,000,000 × 106) together with the interest rate
deposit and option premium US$ 7,123.11 and US$ 13,186.00 respectively.

However, the unrealized loss in the FX transaction :

[ US$ 1,000,000 × (108.65-106.00) ] = JPY 2,650,000
Or ( JPY 2,650,000 / 108.65 ) = US$24,390.24

FX Breakeven level ( b ) :
FX loss = Interest income = US$ 20,309.11 = US$ 1,000,000 × ( b – 106.00)
b
b = 108.20
So, if USD/JPY FX rate goes above 108.20, this DCD will generate loss.
Please graph the payoff diagram of this 3Month USD/JPY DCD.

Figure 77. DCD Payoff diagram

Payoff

US$20,309.11

108.20
0 USD/JPY
106

15. Straddle

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Straddle is one of the most common option strategies traded in the inter-bank market. A Long
Straddle consists of purchasing an equal number of calls and puts, at the same strike price and
maturity. A Long Straddle typically makes to profit from an increasing in Volatility of an
underlying currency pair or precious metal.

Straddle = Composition of a Call and a Put with same strike price and same expiration
date
Buy Straddle = Buy Call and buy Put
Sell Straddle = Sell Call and sell Put
P/L (Straddle) = P/L (Call) + P/L (Put)
Long straddle, buyer will gain when underlying move up or down significantly.
Short straddle, writer earn premium at beginning
Trade is usually done as Delta neutral and volatility play
Net Delta = Call (Delta) + Put (Delta) =0, that is called Neutral Delta

Straddle

Long Call Short Straddle Long Straddle

-P
-C Long Put
X

-C -P Long Straddle

Player strategy

Long straddle trader usually makes profit from an increase in the volatility of an underlying
currency. Buy call option and put option with same strike price, usually are At-the-money, has zero
or low Delta at beginning. Buyer of Long straddle can enjoy unlimited gain if underlying currencies
either jumps or fall in large momentum. At the same time, buyer limits the downside risk to 2
premiums paid.

Writer of straddle gains Call and put option premium but explore to unlimited loss in both up and
down direction.

Figure 78. EUR<Crncy> OVML SD<GO>

Page 82
16. Strangle

A Strangle is similar to a Straddle, with the difference being that out-of-the-money calls and puts
(at different strike prices) are purchased, with the same expiration date.

Strangle, which is similar to straddle, consists of a Put and a Call with same expiration date
and same underlying but different strike prices
Long Strangle = Buy Put (X1)+ Buy Call (X2), where X1 < X2
Short Strangle = Sell Put (X1)+ Sell Call (X2), where X1 < X2

Long strangle is typically used to profit from an increase in volatility of an underlying currency. It
is cheaper than the Straddle because of the different strike prices.

Short strangle trader will result high probability of small profit but also large risk of very big loss
when underlying goes either ways, and he only gains premium from limited movement in quiet
market.

Page 83
 Strangle

Long Put
Long Call Short Strangle

X1 X2
Xp Xc
-P
-C
-P-C Long Strangle
Long Strangle

Figure 79. EUR<Crncy> OVML SN<GO>

Player strategy

Long strangle player expects prices to be very volatile in the short-term. Same view as straddle,
but pay less premium.

Page 84
Buyer of Long strangle, long put option with strike X1 and long call option with strike X2 , gains
unlimited when the underlying price drops or jumps significantly and limits the downside Risk the
Call and Put premiums paid at inception. However, Long strangle position loses value with passage
of time as time value decreases on options.

Writer of Long strangle gains from option premiums only but explore to unlimited loss in both up
and down direction.

17. Risk Reversal

A Risk Reversal strategy consists of purchasing an out-of-the-money call and selling an out-of-
the-money put (or vice versa) at the same expiration date and typically the same notional amount.
A Risk Reversal strategy can be used to make directional bets on the spot price of the underlying
asset or on the relative price of upside and downside protection for that specific underlying asset.
It is a directional play, rather than a volatility play. At inception, this has much less Gamma and
Vega exposure.

Long Risk reversal = Sell Put (X1 ) + Buy Call (X2 ), where X1 < X2 with same expiration date
Short Risk reversal = Buy Put (X1 ) + Sell Call (X2 ), where X1 < X2 with same expiration date

Figure 80. EUR<Crncy> OVML RR<GO>

Figure 80 shows a zero cost Risk reversal option. To construct a zero or low cost Risk reversal
option, press 91) Solve For then select Strike. Leg 2 is the default strike to be solved in
{OVML<GO>}. Insert 0 in either Price or Premium. The second strike will appear in the right-
hand ‘Strike’ field, that is tailor-made to a no cost option.

Page 85
Risk reversal quoted in the market is the difference in volatility between calls and puts with the
same Delta, which conveys information about skew. A positive risk reversal means that the
volatility of Calls is greater than the volatility of Puts with the same Delta. So, risk reversal spread
can be viewed as an indication of market sentiment.

Long Risk Reversal

Payoff
Short PUT, strike at X1

Underlying price

Long CALL, strike at X2

X1 X2

Player strategy

Risk reversal is suited for those who wish to reduce premium costs and to engage into forward
movements. Long Risk reversal gives you a similar outcome as holding an underlying currency,
but you will have no affect if the underlying has low volatility and stay within the range between
2 strikes ( X1 to X2 ).

Alternatively, when you expect EUR to depreciate sharply against USD, Short Risk reversal is a
good speculating instrument; as it costs nothing or small premium at inception and does not inflate
your balance sheet. Whereas, short EUR in cash market will charge you margin interests.

Collar
Risk reversal can be a hedge strategy that consists of selling a Call and buying a Put with the same
Delta and underlying currency, that is known as Collar. Collar protects against downward price
movements but limits the profits that can be made from upward price movements. If spot passes
the purchased strike at expiry, you have full protection. If spot passes the sold strike, you buy or
sell at this strike, that is better than your protection. If spot ends up in between the strikes, you buy
at market with a better price than your protection too. All at zero or low cost.

Player strategy

An exporter needs to purchase EUR in coming 3 months. Spot is currently at 1.4520. Exporter has
a budget to pay EUR at 1.5102 (X2 ). However, investor can improve the exchange rate by getting
into a Collar, that is actually a Risk reversal with underlying currency. Collar is a combination of

Page 86
Short EUR cash and Long EUR Call at 1.5102 (X2 ) and Short EUR Put at 1.3941 (X1 ). See figure
80.

Risk Reversal – FX = Collar

Payout

Spot

Payoff

Scenario 1, when EUR/USD goes above X2 , Call is exercised, but EUR Put option at X1 is
expires worthless.

Scenario 2, when EUR/USD goes below X1 , Put is exercised and buy EUR at X1 . No further profit
from favourable move but he bought EUR better than target rate X2 , 1.5102. Call EUR expires
worthless.

Senario 3, when EUR/USD remains between X1 to X2 . Both Call and Put expire worthless, but
exporter can buy EUR at market, that is still better than target rate X2 , 1.5102.

Page 87
 Enhanced Collar

An Enhanced Collar strategy involves purchasing a Risk Reversal with a Knock-In feature with a
barrier that is out-of-the-money. An Enhanced Collar is a lower risk alternative to Risk Reversal
or Collar strategy.

Figure 81. EUR<Crncy> OVML EC<GO>

Figure 81 shows a zero cost Enhanced collar. To structure a zero cost Enhanced collar in
{OVML<GO>}, click the 91) Solve For on the top red tool bar and select Strike and Leg 2, then
input Price or Premium equals to zero.

Payoff

Underlying price

X1 X2

Page 88
Payoff

Since a Knock-in feature is added into the down side risk, you have a protection at beginning. Until
the underlying currency has triggered the barrier and knock in the option, you start to generate loss.

Scenario 1, if the spot rate does not trade at the barrier ( B ) or the strike, both options are not
exercised then you can buy the currency from market at a better rate than the strike (X2 ).

Scenario 2, if the spot hits the barrier, sell PUT option knocks in then you become Long a synthetic
forward at the strike rate (X1 or X2 ) that is worst than market rate.

Scenario 3, if the spot trade pass the strike X1 , you buy at X1 . Or if the spot trade pass the strike
X2 , you buy at X2 .

Player strategy

Corporate can get into a better than synthetic forward deal with no cost or very low cost. Since a
knock in is added, corporate enjoy a less explores to FX movement than Risk reversal. In Enhanced
Collar, the protection starts from B to X2 , but Risk reversal protects from X1 to X2 .

The company benefits from this strategy only if the real makes an unfavourable move. The
advantage of such a trade is that helps business planning by letting projections of future revenue
and cash flow be made at a known rate.

Same as Risk reversal, corporate engages into Enhanced collar can involve into the currency
forward movement without inflate their balance sheet figure.

Enhanced collar with underlying currency

Enhanced collar with underlying currency can a zero or low cost hedging instrument, that combines
a Collar and a knock-in barrier option. It provides a guaranteed downside protection against
adverse exchange rate movements and allows you to benefit from a favourable exchange rate
beyond the sold strike ( X1 ) , given that spot has not traded beyond a defined barrier ( B ) before
expiry. Therefore, the payoff of Enhanced collar is greater than the payoff of Risk reversal.

Player strategy

Enhanced collar is an alternative of a risk reversal. Firm, that is not interested in directional trade,
will hedge their short currencies explore by engaging into it with no or very low cost. Firm will do
this trade when it expects that underlying currency (EUR) is more likely to strengthen during this
year but still wants to benefit from any return if EUR weakens surprisingly.

When firm need to pay foreign currency, such as EUR, within one year but they have short term
liquidity concern or cannot pay EUR immediately, they will Long an Enhanced collar shown in
figure 81. The firm gets protection and minimizes the loss under a non-favour market move.
However, the profit in a favour market is also limited at the barrier.

Page 89
 Payoff

PEC

PRR B Underlying price

X1 X2

Payoff

Scenario 1, if barrier 1.2690 (B) is never hit during the life of the Enhanced collar and spot is above
1.5264 ( X2 ) at expiry, the option buyer buys EUR sells USD at 1.5264 ( X2 ). On the other side,
if spot goes below 1.4161 ( X1 ) , the option buyer buys EUR sell USD at the prevailing market
rate.

Scenario 2, if barrier 1.2690 (B) is hit during the life of the option, the enhanced collar becomes a
simple Collar with strikes ( X1 & X2 ). When spot at expiry rises above 1.5264 ( X2 ), the option
buyer buys EUR sells USD at 1.5264( X2 ). On the other hand, spot drops below 1.4161( X1 ), the
option buyer is obliged to buy EUR sell USD at 1.4161( X1 ). Whereas, spot lies between X1 & X2,
the option buyer buys EUR sells USD at prevailing market rate.

Page 90
18. Participating forward

Participating Forward, also known as Synthetic forward, consists of simultaneously purchasing a

call (or Put) option and selling a Put (or Call) option, that is identical to the Risk Reversal strategy,
except that is at the same expiration and strike and same notional amount.

Long Participating Forward = Buy Call + Sell Put with same strike ( X1 ), same expiration
and same notional amount.
Short Participating Forward = Sell Call + Buy Put with same strike ( X1 ), same expiration
and same notional amount.
Long Participating forward
Payoff

Underlying price

X1

Participating forward can also set to different notional amount in 2 legs in order to adjust a zero or
low upfront cost, that is commonly used to hedge exchange rate risk while allowing the hedger to
participate in favorable exchange rate fluctuations to a certain extent.

Long Participating Forward = Buy Call + Sell Put with same strike ( X1 ), same expiration
but different notional amount.
Short Participating Forward = Sell Call + Buy Put with same strike ( X1 ), same expiration
but different notional amount.

Figure 82. EUR<Crncy> OVML PF<GO>

Page 91
Figure 82 shows a 1 year zero cost EUR/USD Participating forward. To set up this zero cost option,
Notional of one leg need to be adjusted. In {OVML<GO>}, click into 91) Solve For : Notional
then select a leg. Type in zero in to Price or Premium to get notional field calculate.
Long Participating forward with different notional
Payoff

Short Put, small notional

Underlying price
Long Call, big notional

X1

A participating forward is a form of risk reversal, but the strikes are the same but the principal
amounts differ. Essentially, you lock in an exchange rate now while leaving a portion of your
investment option to participation in favourable exchange rate movements. In order to enlarge the
up side potential, Participating forward buyer Long a large notional Call option and Short a small
notional Put option. As a result, when spot rises over the strike ( X1 ), buyer can purchase large
amount of currency at strike price and enjoy big profit. Alternatively, when spot performs weakly
and stay below the strike level, Put option will be exercised. Player has the obligation to buy
currency at strike price but for a smaller amount, so loss is reduced.

Player strategy

Traders engage into a Participating forward into order to have a directional trade without upfront
cost. The company benefits from this strategy only if the real makes an unfavourable move. The
advantage of such a trade is that helps business planning by letting projections of future revenue
and cash flow be made at a known rate.

Firm expect EUR appreciate, he will Long Participating forward and enjoy FX market movement.
If the firm needs to purchase EUR 1 million in 1 year time, he can buy a EUR 1 million Call and
sell a EUR 500,000 Put with strike 1.5024 ( X1 ) at no cost, see figure 82. As a result, if EUR
appreciates and climb over 1.5024 ( X1 ), he buy EUR 1 million at 1.5024 as fully hedged. If EUR
falls below 1.5024( X1 ), he has the obligation to purchase EUR 500,000 at 1.5024 but the rest
amount from spot market at a better price. He takes advantage from the partial hedging in
favourable market condition.

By contrast, a currency forward contract protects a company against unfavourable changes in FX

rate but it also eliminates the ability for the company to participate in favourable exchange rate
movement. Also, option will not inflate the balance sheet.

Page 92
 Forward Extra

Forward Extra strategy is a combination of a Participating forward plus a Knock-in feature with an
Out-of-money barrier added into the Put option with same strike level. Forward extra is identical
to Enhanced Collar, that is slightly lower risk exposure than Participating forward.

▪ Long Forward Extra = Buy Call + Sell Knock-in Put, with same strike ( X1 )
▪ Short Forward Extra = Sell Call + Buy Knock-in Put, with same strike ( X1 )

Payoff

Since a Knock-in feature is added into the down side risk, you have a protection at beginning. Until
the underlying currency has triggered the barrier and knock in the option, you start to generate loss.

Scenario 1 in a quiet market, the spot rate does not hit Barrier ( B ) nor the strike ( X1 ), the Put
options will not be exercised then you can buy the currency from market at a better rate than the
strike ( X1 ). Or, if the spot trade pass the strike ( X1 ), you buy at X1.

Scenario 2, the spot hits the barrier, sold PUT option knocks-in then you become Long a synthetic
forward at the strike rate ( X1 ). So, you need to purchase the currency at strike ( X1 ) regardless
the spot goes up or down at expiry.

Long Forward Extra

Payoff

B
Short Put, with strike X1 &
Knock-in

Underlying price

Long Call, with strike X1

X1

Figure 83. EUR<Crncy> OVML FE<GO>

Page 93
Figure 83 shows a zero cost 1 Year EUR/USD Forward Extra. To construct a zero cost or low
upfront cost forward Extra, Barrier level need to be adjusted. In {OVML<GO>}, click 91) Solve
For on top of the red tool bar and select Barrier. Type zero to Price or Premium.

Player strategy

Forward Extra is better than Participating forward deal. Corporate can enhance value of a synthetic
forward with no cost or very low cost. Since a knock in is added, corporate enjoy a small protection
starting a FX range from B to X1 . Whereas Participating forward totally explores to market
movement.

Company engages in Forward Extra for directional trading at no or low cost at beginning. However,
company benefit from this traded only if the real makes an unfavourable move. The advantage of
such a trade is that helps business planning for future cash flow by fixing a known rate. It will not
inflate the balance sheet.

Forward Extra with underlying currency

Forward Extra can be a zero or low cost hedging instrument, if a short position in underlying
currency exists. It can be created by selling a knock-in barrier Put option, buying a Call with same
strike and shorting the currency. It provides a guaranteed downside protection against adverse
exchange rate movements and allows you to benefit from a favourable exchange rate beyond the
Put strike ( X1 ) , given that spot has not traded beyond a defined barrier ( B ) before expiry.
Therefore, the payoff of Forward Extra is greater than the payoff of Participating forward.

Page 94
 Long Forward Extra with Short currency
Payoff
Long Forward Extra, with
strike X1 & Knock in

PFE
B Underlying price
PPF

Short Currency
X1

Payoff

Forward Extra with underlying enables a company to reduce the downside risk in unfavourable FX
market, while enjoying the benefit of favourable currency movements up to a negotiated Barrier
level (B). As long as the spot rate never reaches the barrier (B) nor hits the strike ( X1 ), the
company will buy purchase the currency at prevailing rate that is better than the strike ( X1 ). If the
spot climbs over the strike, company can purchase at strike ( X1 ) that is cheaper than market rate.
However, if Barrier is hit and Put option knocks-in, company has the obligation to purchase at X1 .

Longing Forward Extra shown in figure 83, the firm will be protected and reduce loss under a non-
favour market move. However, the profit in a favour market is also limited at the barrier (B).

Scenario 1, barrier 1.1425 (B) is never hit during the life of the Forward Extra and spot is above
1.5260 ( X1 ) at expiry, the option buyer buys EUR sell USD at 1.5260 ( X1 ). On the other side, if
spot goes below 1.5260 ( X1 ) without touching barrier 1.1425 (B), the option buyer buys EUR sell
USD at the prevailing market rate.

Scenario 2 barrier 1.1425 (B) is hit during the life of the option, the Forward Extra becomes a
simple forward with strike ( X1 ). When spot at expiry rises above or below 1.5260 ( X1 ), the
option buyer buys EUR sell USD at 1.5260.

Player strategy

Forward Extra with underlying currency is a hedging instrument with no or very low cost. Firm
will do this trade when it expects that underlying currency (EUR) is more likely to strengthen
during this year but still wants to benefit from any return if EUR weakens surprisingly. When firm
need to pay EUR within one year but they have short term liquidity concern or cannot pay EUR
immediately, they will Long Forward Extra. The amount of future payment is ascertained by
locking into a known rate, cashflow and business plan can be projected easily.

Forward Extra has disadvantage to Enhanced Collar, after barrier (B) is hit protection in Forward
Extra disappears but the protection range ( X1 to X2 ) still exists in Enhanced Collar.

19. Call / Put Spread

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Call/Put Spread strategy can be constructed by buying and selling Call or Put with same maturity
but different strikes. This strategy can be used to make directional bets with low risk with limited
profit.

Bull Spread : Call Spread = Buy Call ( X1 ) + Sell Call ( X2 ), where X1 < X2
Buyer of Bull spread gains profit if underlying price rises, with limit upside potential and limit
risk exposure.

Bear Spread : Put Spread = Sell Put ( X1) + Buy Put ( X2 ), where X1 < X2
Buyer of Put spread earns if Spot rate drops, but the upside potential and risk are limited.

Long Bull Spread or Long Call Spread Long Bear Spread or Long Put Spread
Payoff Payoff
Long Bull Spread
Or
Short Put (X1)
C2 Long Call spread P1

Underlying price
Underlying price Long Bear Spread
C2 –C1 P2 –P1 Or
Long Put spread
X2
X1
-C1 Long Call (X1) Short Call (X2)
-P1
Long Put (X2)

X1 X2

＊ Long Bull spread = Short Bear spread ＊ Short Bull spread = Long Bear spread
＊ Long Call spread = Short Put spread ＊ Short Call spread = Long Put spread

Payoff

Long Bull spread or Long Call spread :

Scenario 1, spot drops below strike X1 at expiry, both Call options expire worthless. You can buy
EUR sell USD at a cheaper rate from the market.

Scenario 2, if spot lies in between X1 and X2 , the option buyer can exercise the Long Call and buy
EUR sell USD at X1.

Scenario 3, when spot at expiry jumps over X1 level, the option buyer exercises Long Call option,
buys EUR sells USD X1 . At the same time, he obliges to sell EUR buy USD at X2 then earns from
the spread between X1 and X2 . Profit is limited by Short Call at X2 .

Long Bear spread or Long Put spread :

Page 96
Scenario 1, spot is above strike X2 at expiry, both Put options expire worthless. You can sell EUR
buy USD at a higher price in the market.

Scenario 2, if spot lies in between X1 and X2 , the option buyer can exercise the Long Put and sell
EUR buy USD at X2.

Scenario 3, when spot at expiry falls lower than X1 level, the option buyer exercises Long Put
option, sells EUR buys USD at X2 . Simultaneously, he obliges to buy EUR sell USD at X1 . His
profit is generated from the spread between X1 and X2 , that is limited by Short Put at X1 .

Figure 84. EUR<Crncy> OVML CP<GO>

Player strategy

Trader, that has moderate directional view, will engage into a Call / Put spread. Call / Put spread
is more preferable than vanilla point because of low premium payment at inception.

Trader, who longs a Call spread as shown in figure 84, expects that underlying currency (EUR) is
more likely to strengthen during within 3 months and wants to benefit from any gain at a lower
cost. However, upside potential is limited in order to compensate the low risk exposure and low
premium EUR3,084. The maximum loss in this trade is the premium EUR 3,084 only.

The maximum profit occurs when EUR/USD spot rises over X2 :

Long Call option is exercised at 1.4500, trader buys EUR 1,000,000 sells USD1,450,000.
Short Call option is also exercised at 1.46, trader sells EUR 1,000,000 buys USD 1,460,000.
Generate profit USD 10,000 at maturity.

Figure 85. JPY<Crncy> OVML CP<GO>

Page 97
Trader, who longs a Put spread as shown in figure 85, expects that underlying currency (JPY) will
strengthen by 6 months and try to benefit from any gain at a lower cost. However, upside potential
is limited in order to compensate the low risk exposure and low premium USD14,580.55 which is
the maximum loss.

The maximum profit occurs when USD/JPY price falls under X1 :

Long Put option is exercised at 91.00, trader sells USD1,000,000 and buys JPY 91,000,000.
Short Put option is also exercised at 88.00, trader buys USD1,000,000 and sells JPY 88,000,000.
Generate profit JPY 3,000,000 at maturity.

20. Calendar Spread or Horizontal Spread

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A Calendar Spread, that is also known as Horizontal Spread, is created by selling a short-tenor
option and buying a long-tenor option of the same type (Call or Put) with same strike and same
notional. A Calendar Spread is usually used in a neutral market outlook and to take a position in
forward volatility or in the implied forward volatility surface. Cost of Long option is decreased by
the premium received from Short option, but premium cannot be zero because of more time value
imbedded in longer tenor option given the same strike level.

Long Calendar Spread = Sell (short-tenor) + Buy (long-tenor)

Short Calendar Spread = Buy (short-tenor) + Sell (long-tenor)
Long Call Calendar Spread
Long 1year Call
Payoff

Short 6month Call

1 Year Payoff

Underlying price

X1
6 month Payoff

Payoff

Long Call Calendar spread :

Phrase 1 after 6 months, spot drops below strike X1 at expiry, the sold Call options expire worthless.
You have a vanilla Call at X1 that still exists for other 6 months time. If the spot climbs over X1 ,
you have obligation to sell currency at X1 and lose realized that may be significant.

Phrase 2 after 1 year, when FX rate declines to below X1 , no option is exercised then you earn
nothing. If FX at expiry jumps over X1 , you can exercise Long Call option and buy currency at
X1 . Upside potential is also unlimited.

Short Call Calendar spread :

Writer earns option premium at the beginning. If spot climbs over X1 , he may have unlimited gain
in phrase 1. However, if FX is still above X1 at the end, writer will face a downside risk.

Long Put Calendar spread :

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Phrase 1 spot rises over strike X1 by 6 months, the sold Put expires worthless. You have a vanilla
Put with strike X1 for another 6 months period. Whereas the FX rate falls below X1 , you need to
purchase the currency at X1 and realize lose.

Phrase 2, when FX falls lower than X1 in 1 year, the option buyer exercises Long Put option and
enjoy profit from the favour market.

Short Put Calendar spread :

Writer earns option premium at the beginning. If spot drops below X1 , he may have unlimited gain
in phrase 1. However, if FX is still under X1 at maturity, writer will face a downside risk in phrase
2.

Figure 86. EUR<Crncy> OVML CS<GO>

Player strategy

Investor has point of view that the FX market is salient without any direction or currency is
weakening in short term but FX market will rally or currency performance will rebound later.

In figure 86, the investor purchases a 6 month Call option with strike 1.4600 X1 and sells 1 year
Call option with same strike 1.4600 X1. He will enjoy a maximum upside potential if FX rate never
drops blow strike 1.4600 X1 then the 6 month Call option expires worthless. After all, he will hold
the 1 year vanilla Call option only with unlimited upside potential.

Alternatively, when both options are not exercised, he loses the premium EUR14,737 that paid
initially. Nonetheless, the sold 6 month Call option may be exercised against him then downside
risk is large.

21. Diagonal Spread

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Diagonal Spread consists of a Long and Short the same type of option (Call or Put), but with
different strikes and maturities. A Diagonal Spread can be used to take a position in forward
volatility or in the implied forward volatility surface. Cost of Long option is decreased by the
premium received from Short option, so Diagonal spread is at low or zero cost.

Call Diagonal Spread = Buy Call + Sell Call, with different strikes and different expiration.
Put Diagonal Spread = Buy Put + Sell Put,

Payoff
Call Diagonal Spread
Long 1year Call (X2)
Payoff
Short 6month
Call (X1)
1 Year Payoff

Underlying price

X1 X2
6 month Payoff

Phrase 1 by the time of shorter (e.g. 6 month) tenor option matures, the spot stays below the strike
X1, the sold Call option expires worthless. If the spot rises over the strike X1, you obligate to sell
currency at the strike that is lower than market rate, and you lose money.

Phrase 2 the longer tenor option matures in 1 year, the spot does not reach the strike X2, the Call
option expires worthless. If the spot jumps beyond the strike X2, the Call option is exercised and
you will start to gain.

Figure 87. EUR<Crncy> OVML DS<GO>

Page 101
Player strategy

Investor has point of view that the FX market is salient without any direction or currency is
weakening in short term but FX market will rally or currency performance will rebound later.

In figure 87, the investor sells 6 month Call option with strike 1.4600 X1 and buys 1 year deep Out-
of-money Call option with strike 1.4800 X2. He will enjoy a maximum upside potential if FX rate
never hits strike 1.4600 X1 then the 6 month Call option expires worthless. After all, he will hold
the 1 year vanilla Call option only with unlimited upside potential.

Alternatively, when both options are not exercised, he loses the premium that paid initially. The
sold 6 month Call option may be exercised against him then downside risk is large.

22. Seagull
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Seagull strategy consists of buying ATM option and selling a Strangle, where the option and
strangle have the same expiration date and usually also have the same notional amount.

Short Strangle is to finance the purchase of the ATM option, which makes this strategy at low or
zero cost. Long Seagull, which holds an ATM Call, would be appropriate if the trader has a bullish
market outlook. Whereas a Short Seagull, that sells an ATM Call, is suitable to trader who has a
bearish market view.

Long Seagull = Buy Call (ATM, X2 ) + Sell Call (OFM, X3 ) + Sell Put (OFM, X1)
= Sell Put (ATM, X2 ) + Buy Call (OFM, X3 ) + Buy Put (OFM, X1 )

Short Seagull = Sell Call (ATM, X2 ) + Buy Call (OFM, X3 ) + Buy Put (OFM, X1 )
= Buy Put (ATM, X2 ) + Sell Call (OFM, X3 ) + Sell Put (OFM, X1 )
with same expiry and same notional amount

Long Seagull = Buy Call(ATM) +Sell Call(OFM) +Sell Put(OFM)

Buy CALL (ATM)

Payoff

COFM
POFM Sell PUT (1.40)
0
COFM+POFM-CATM
Underlying
price
-CATM

1.40 1.45 1.50

X1 X2 X3
Sell CALL (OFM)

Payoff

Scenario 1 the spot rate below strike X1, Sold Put option will be exercised and you obligate to buy
currency at X1 then realize loss that can be significant; but other 2 Call option expire worthless.

Scenario 2 the spot rate stays between X1 and X2 at maturity, all options expire worthless. Option
premium (COFM+POFM-CATM) paid at beginning is your loss.
Scenario 3 when the spot rate lies between X2 and X3 at maturity, Call(ATM) option can be
exercised and you can buy currency at X2 cheaper than prevailing market price, but other 2 OFM
options expire worthless.

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Scenario 4 if the spot jump over between X3 eventually, sold Put option expires worthless but 2
Call options will be exercised. You can buy currency at X2 , but you also obligate to sell currency
at X3 that limits you upside potential. The maximum gain is the different between X2 and X3 .
Example shown in figure 88, the maximum profit earns when EUR/USD is above 1.5000.
Long Call(ATM), you buy EUR 1,000,000 sell USD 1,450,000
Short Call(OFM), you obligate to sell EUR 1,000,000 buy USD 1,500,000
Generate maximum profit USD 50,000.

Figure 88. EUR<Crncy> OVML SG<GO>

Player strategy

Seagull buyer has bullish view in FX market and try to benefit from the upward movement with
no or low cost. Buyer enjoys the FX movement as long as the spot rate does not go further than the
highest strike X3 , as the maximum profit is limited by the sold Call option. However, when FX
market goes against the buyer, turn to opposite direction and below the smallest strike X1 level, the
potential loss can be huge.

Bearish player can short Seagull and look for profit from downward market when spot rate falls
under the smallest strike X1 . Seagull has advantage over short real currency because of the margin
cost charges in cash market.

Comparing to Risk reversal in chapter 17, both are no or low cost structure but Seagull has upside
potential limited that is a disadvantage. However, Seagull starts At-the-money, whereas Risk
reversal begins Out-of-money.

23. Butterfly

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Long Butterfly option strategy is commonly used when the spot price of the underlying asset is not
expected to move much over the life of the position. So, Long Butterfly structures benefit when
volatility falls. A short Butterfly is commonly used when the spot price of the underlying asset is
expected to move a large amount over the life of the position, in other words, long volatility. Also,
Short Butterfly has advantage in highly volatile environment.

3 Legs Butterfly
Long Butterfly = Buy Call (X1) + Buy Call (X3) + Sell 2 Calls (X2)
= Buy Put (X1) + Buy Put (X3) + Sell 2 Puts (X2)

Short Butterfly = Sell Call (X1) + Sell Call (X3) + Buy 2 Calls (X2)
= Sell Put (X1) + Sell Put (X3) + Buy 2 Puts (X2)
where X1 < X2 < X3

Long Butterfly can also be constructed Long 1 OTM Strangle and Short 1 ATM Straddle, with the
same expiration date across all the options. A Short Butterfly can be created by selling Strangle
and purchasing Straddle.

Iron Butterfly = Strangle + Straddle

Long Butterfly = [ Buy Put (X1) + Buy Call (X3) ] + [ Sell Put (X2) + Sell Call (X2) ]
Short Butterfly = [ Sell Put (X1) + Sell Call (X3) ] + [ Buy Put (X2) + Buy Call (X2) ]
where X1 < X2 < X3

Long Butterfly = Long Strangle + Short Straddle

Payoff

C2 & P2 Long Call(X3)

Underlying
price
C2+P1-C3-P2

-C3 & -P3 Long Put (X1)

X1 X2 X3
Short Put(X2) Short Call(X2)

Page 105
 Payoff Payoff

Short Butterfly
Premium

Underlying price e1 e2
e1 e2
X2 Underlying price
Premium
Long Butterfly

X1 X2 X3
X1 X3

Figure 89. EUR<Crncy> OVML BF<GO>

Payoff

Figure 89 shows Long EUR 3month Butterfly.

Scenario 1 the Spot rate drops below strike 1.4000 (X1), Long Put(X1) and Short Put(X2) at 1.4500
options can be exercised; but Long Short Put options have net off effect. Other 2 options expire
worthless, so you make no change but lose the option premium.

Scenario 2 the Spot rate stays within 1.40 to 1.45 (X1 & X2), Long Call(X3), Long Put (X1) and
Short Call(X2) expire worthless; but only Short Put(X2) is exercised. You obligate to buy EUR
sell USD at 1.45(X2), meaning purchasing EUR higher than market price.

Scenario 3 the Spot rate lies between 1.45 to 1.50 (X2 & X3), Short Put(X3), Long Call(X3) and
Long Put(X1) expire worthless; but only Short Call(X1) is exercised. You obligate to sell EUR buy
USD at 1.45 (X2), selling EUR cheaper than market.

Page 106
Scenario 4 the Spot rate jumps over 1.5000(X3), Long Put(X1) and Short Put (X2) expire worthless;
but Long Call(X3) and Short Call(X2) can be exercised. Since Long Short Call have offset each
other, you are indifferent. You only gain comes from option premium.

When FX rate is below e1 or jumps over e2, you start to loss and your maximum lost is the initial
payment of option premium EUR20,707. It starts earning when FX spot rises from e1 to e2, and
profit is topped at strike 1.4500 ( X2 ).
Long Call(1.5000), option value equals to zero when EUR/USD is at 1.4500.
Long Put(1.4000), option value equals to zero too.
Short Call(1.4500), you sell EUR 1,000,000 buy USD 1,450,000
Short Put(1.4500), you buy EUR 1,000,000 sell USD 1,450,000.
So, maximum profit comes from the premiums of Short Call and Short Put (Short Straddle).

On the other hand, Short butterfly suffer when FX spot stay between e1 to e2 , but you begin to gain
when currency price is under e1 or over e2 .

Player strategy

Long Butterfly investors think that the market will be a side way market with a narrow range. They
want to make profit in the quiet market but don’t want to bear big downside risk. Traders long
Butterfly when they forecast the FX market will become quiet and volatility will decline.

Short Butterfly investors expect the FX rate will move dramatically in either direction. They only
suffer a downside risk within a narrow range but benefit from large market movement and gain
from volatility.

24. Condor

Condor strategy consists of Long a Strangle and Short another Strangle, which is also known as
Strangle spread, ensuring that the interval between the strikes for the short Strangle is smaller than
the interval between the strikes of the larger Strangle. Long Condor player expects the price of the
underlying be stable and volatility fall. Whereas Short Condor player forecasts the FX price would
not be stable and volatility rise.

Long Iron Condor = Long large interval Strangle + Short small interval Strangle
= [ Buy Call (X4) + Buy Put (X1) ] + [ Sell Call (X3) + Sell Put (X2) ]

Short Iron Condor = Short large interval Strangle + Long small interval Strangle
= [ Sell Call (X4) + Sell Put (X1) ] + [ Buy Call (X3) + Buy Put (X2) ]

Condor can also be constructed from 4 Calls or 4 Puts component with 4 different strike prices.

Page 107
 Long Call Condor = Buy Call (X1) + Buy Call (X4) + Sell Calls (X2) + Sell Calls (X3)
Long Put condor = Buy Put (X1) + Buy Put (X4) + Sell Puts (X2) + Sell Puts (X3)

Short Call Condor = Sell Call (X1) + Sell Call (X4) + Buy Calls (X2) + Buy Calls (X3)
Short Put Condor = Sell Put (X1) + Sell Put (X4) + Buy Puts (X2) + Buy Puts (X3)
where X1 < X2 < X3 < X4

Condor

Short Put (X3)

P3 Short Condor
P2
Short Put (X2)
0
-P1
Long Put (X1)
X1 X2 X3 X4
-P4
Long Put (X4) Long Condor

Payoff Payoff
Short Condor
Premium

e1 e2 Underlying price e1 e2 Underlying price

Premium
Long Condor

X1 X2 X3 X4 X1 X2 X3 X4

Page 108
 Long Condor = Long big Strangle + Short small Strangle

Payoff

C3
Underlying
P2
price
0
-P1
C3+P2-C4-P1 Buy PUT (1.30)

1.30 1.40 1.50 1.60

-C4
Buy CALL (1.60)
Sell CALL (1.50)
Sell PUT (1.40)

Figure 90. EUR<Crncy> OVML CR<GO>

Page 109
Payoff

Figure 90 shows Long EUR 1year Condor. Scenario 1 the Spot rate falls below the smallest strike
1.3000 ( X1 ), Long Call( X4 ) and Short Call ( X3 ) expire worthless; but Long Put( X1 ) and Short
Put( X2 ) are exercised. Since Long Short Put have offset each other, you realize a limited loss of
USD100,000.
Long Put( X1 ), you sell EUR 1,000,000 buy USD 1,300,000
Short Put( X2 ), you need to buy EUR 1,000,000 sell USD 1,400,000
You lose USD 100,000.

Scenario 2 the Spot rate stays between 1.30 to 1.40 ( X1 & X2 ), Short Call( X3 ), Long Call( X4 )
and Long Put( X1 ) expires worthless; but only Short Put( X2 ) is exercised. You obligate to buy
EUR/USD at 1.40 that is more expensive than market.

Scenario 3 the Spot is stable at 1.40 to 1.50 ( X2 & X3 ), all 4 options expires worthless. Maximum
profit comes from Short small interval Strangle (Put( X2 ) & Call( X3 )).

Scenario 4 the Spot jumps over the largest strike 1.6000( X4 ), Short Put( X2 ) and Buy Put( X1 )
expire worthless; but Long Call 1.60( X4 ) and Short Call 1.50( X3 ) are exercised. Since Long
Short Call offset each other, you only lose the different of 2 strikes.
Long Call( X4 ), you buy EUR 1,000,000 sell USD 1,600,000
Short Call( X3 ), you have to sell EUR 1,000,000 buy USD1,500,000
You lose USD 100,000.

If the Spot rate drops below e1 or jumps over e2, you start to loss and your maximum lost is the
initial payment of option premium EUR33,911. You start earning when FX spot rises from e1 to
e2, and profit is capped between strikes 1.40 to 1.50 ( X2 & X3 ).

On the other hand, Short Condor suffer when FX spot stay between e1 to e2 , but you begin to gain
when currency price is under e1 or over e2 .

Player strategy

Long Condor investors think that the market will be a side way market within a range. They want
to make profit in the quiet market but don’t want to take large downside risk.

Short Condor investors expect the FX rate will move extraordinary in either direction. They only
suffer a downside risk within the range but benefit from large market movement.

Condor takes the body of the butterfly (two options at the middle strike (X2) ) and splits it between
two middle strikes rather than just one. In this sense, the condor is a butterfly stretched widely.
Compared with butterfly, Long Condor provides a greater protection as it has a wider range of
gaining small profit with no or low cost.

Page 110
25. Knock-in & Knock-out

Barrier options are options that behave in a certain way depending on whether the spot of the
underlying currency reaches or surpasses a barrier, or multiple barriers. {OVML<GO>} provides
a variety of different barrier options, the simplest being Knock In / Out options, which are Vanilla
options that either come in to existence (Knock In) or cease to exist (Knock Out) when the spot of
the underlying currency reaches a pre-defined barrier. {OVML<GO>} provides other, more
complex, Barrier options that are similar to Knock In / Out’s, such as Double Knock In / Out, No
Touch, and One Touch options. Many of the other styles of options, such as Risk reversal,
Participating forward and Digital, use Barrier features to create more complex option structures.

Knock-out
Knock-out option is a vanilla Call or Put option that expires worthless if the barrier price
level is reached before expiration.

Knock-in
Knock-in option is a latent option contract that becomes a normal vanilla Call or Put if the
barrier price level is reached before expiration.

Double knock-out
Double knock-out is a vanilla call or put option that expires worthless if One of two barrier
prices is reached before expiration. The two barriers are set above and below the initial
spot.

Double knock-in
Double knock-in is a latent option contract that becomes a normal vanilla call or put if One
of two barrier prices is reached before expiration. The two barriers are set above and below
the initial spot.

No-touch
No-touch option pays a fixed amount if the market never touches a specified barrier level
prior to expiration.
The price of the no-touch varies with 3 factors:
(a) Tenor: the longer, the cheaper. The longer the option, the more likely the barrier
will be breached.
(b) Moneyness: the closer the barriers are to the implied forwards, the cheaper the
option, since the barrier is more likely to be breached.
(c) Volatility: the higher the volatility of the underlying, the cheaper the option. The
more volatile the underlying the more likely the barrier will be breached.

One touch
One touch option pays a fixed amount if the market touches a specified barrier level prior
to expiration.

Double no-touch

Page 111
 Double no-touch option pays a fixed amount if the market does not touch either of two
specified barrier levels prior to expiration. The barrier levels are set above and below the
initial spot.
Price of a Double no-touch is not the addition of two no-touch options. If this were the
case, once one barrier had been breached, the other no-touch option would still be ‘alive’.
A double no-touch is the addition of two ‘contingent’ no-touch options. A ‘contingent’ no-
touch option is one where the survival of one no-touch option depends on the barrier of the
other no-touch option not being breached.
The price of the double no-touch varies with 3 factors:
(a) Tenor: the longer, the cheaper. The longer the option, the more likely the barrier
will be breached.
(b) Moneyness: the closer the barriers are to the implied forwards, the cheaper the
option, since the barrier is more likely to be breached.
(c) Volatility: the higher the volatility of the underlying, the cheaper the option. The
more volatile the underlying the more likely the barrier will be breached.
Player strategy: investors who believe that market will be range-bound.

Double one touch

Double one touch option pays a fixed amount if the market touches either of two specified
barrier levels prior to expiration. The barrier levels are set above and below the initial spot.
Player strategy: trading economic releases that will create big impact to the market. Double
one touch options let you speculate that an economic announcement will move the market,
without worrying about the direction of the move.

Knock-in Knock-out option (KIKO)

Knock-in knock-out (Non-sequential) option has double barriers. If the knock-in barrier is hit
before the knock-out barrier, the option becomes a Knock-out. If at any time the Knock-out barrier
is hit, the option disappears.

The Knock-out barrier takes precedence over the Knock-in barrier, if the Knock-out barrier is hit
before the Knock-in is touched, the option is knocked out immediately. Type {OVML KOKI<GO>}
to pull out this product.

There is another Knock-in Knock-out (sequential) option also has double barriers, but it has slightly
different. This Knock-in option can be deactivated when the Knock-out barrier is reached.
However, if the Knock-in barrier is reached first, it can no longer Knock-out. Or if the Knock-out
level is reached first, it can no longer Knock-in. Run {OVML KIKOSQ<GO>} to put it out.

Figure 91. AUD<Crncy> KOKI<GO> Knock-In Knock-out Non-sequential

Page 112
 Long KIKO non-sequential
Payoff

B(Down & In) Underlying

price

Premium B(Up & Out)

X1

Payoff

Scenario 1 AUD/USD is traded side way but not touching 2 barrier 0.8400 nor 0.9000, the option
expires worthless.

Scenario 2 AUD/USD falls below 0.8400 and hitting the Knock-in barrier first, option become a
Call AUD at 0.8600 with Knock-out. If AUD/USD never touches 0.90 before expiration, Call
option can be exercised and you can buy AUD/USD at 0.8600. Unfortunately if AUD/USD climbs
to hit 0.9000, your option terminates immediately. Your maximum loss is the premium.

Scenario 3 AUD/USD touches 0.9000 first, your option terminates immediately. Your maximum
loss is the premium, that is AUD 1,546.

Player strategy

KIKO is very popular FX option strategy in Private Banking. PB clients like to sell Knock-in
knock-out options to the banks and receive option premium. The Knock-out barrier is placed at
level very close to the current spot FX rate so as to increase the likelihood of a knock-out.
26. Digital

Page 113
Digital options are another style of options available in {OVML<GO>}. The plain Digital or
known as Binary option, that is either 1 or 0, is one where the payoff is either a specific nominal
amount or nothing, with the payoff depending on whether the option is either ITM or OFM.

If the option is OFM at expiration, option is worthless. In the other hand, if the option is ITM,
payoff is a fixed amount that agreed at the inception.

Plain Digital
Digital option provides a predetermined fixed payoff on the expiry date provided that the
spot is greater than the strike of Call option or the spot is less than the strike of Put option.

In addition to plain Digital options, {OVML<GO>} also offers more complex Digital options that
are coupled with the features of Barrier options mentioned above. Examples of these include
Digital Knock In/Out and Digital One Touch options.

Digital Knock-out
Digital Knock-out provides a predetermined fixed payoff on the expiry when the Spot is
greater than the strike of Call option and given that the Barrier has not been hit during the
life of option, alternatively the Spot is less than the strike of Put option and provided that
the barrier has never been hit before maturity.

Digital Knock-in
Digital Knock-in gives a predetermined fixed payoff on maturity date when the Spot is
greater than the strike of Call option and provided that the Barrier has been touched during
the option life or the Spot is less than the strike of Put and given that the Barrier has been
hit before expiration.

Digital Double Knock-out

Digital Double Knock-out is same as Digital Knock-out but with 2 barriers at above and
below the strike, that provides a predetermined fixed payoff on expiry given that both
barriers are never triggered before the life of option.

Digital Double Knock-in

Digital Double Knock-in is similar to Long Digital Double Knock-in
Digital Knock-in but consists of 2 Payoff
barriers at above and below the strike,
that return a predetermined fixed payoff B(Down & In) Underlying
on maturity given that One of the price
barriers is touched during the option
life.
Premium B(Up & In)
X1

27. Average option

Page 114
Path Dependent options are defined as path dependent because their value is not only determined
by the Spot of the underlying currency at expiration or exercise but also the Spot of the currency
at various other times over the life of the option. Accrual option, Average option, Accumulator are
examples of Path Dependent option.

Accrual option
Accrual option pays a certain percentage of a total predefined payoff at a predefined
frequency until expiration, only if the Spot of the underlying currency falls within two
barriers at the time a payment is due. So, the total payoff received, by maturity, will depend
on where the spot of the underlying currency was throughout the life of the Accrual option.

Average option

Asian Options, also known as “Average Options”, are options whose payments at maturity depends
on a-in real world-discretely monitored average of underlying prices. There are 2 basic of Asian
Options : Fixed Strike Options (Average Price Options or Average Rate Options) and Floating
Strike Option (Average Strike Options). The first type pays at maturity the difference- if positive-
between some arithmetic mean of the underlying and a predetermined strike price within the start
date and end date. The second type pays at maturity the difference-if positive-between the
arithmetic mean and the underlying price at maturity. Asian Options are normally European-style
options.

An Average option is similar to a vanilla option, but the payoff is determined by the different
between the strike price and the average (or fixed) spot prices within the start date and end date. It
has a payoff that is the spread between the average FX rate of a given period to the strike price :

Call note = MAX [ 0, Average ( S1, …, SN ) – K ]

Put note = MAX [ 0, K – Average ( S1, …, SN ) ]
where :
Sj = price of the underlying observed at time T j , j = 1, …, N
Tj ≤ TN
T N = option expiry
X = strike

Average can be either :

Arithmetic Average (S1, …, SN ) = ( S1 + …+ SN ) / N
Geometric Average (S1, …, SN ) = ( S1 × …× SN )1/N

In {OVML <GO>}, the weighted averages are :

Weighted Arithmetic Average (S1, …, SN ) = (W1S1 + …+ WN SN ) / ( W1 + …+ WN )
Weighted Geometric Average (S1, …, SN ) = ( S1W1 × …× SN WN )1/( W1 + …+ WN )
where : Wj = weightings
Figure 92. AUD<Crncy> OVML AVG<GO>

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Figure 92 shows a 3 Month Call AUD/USD Weekly Average option, that payoff according to the
Arithmetic average of AUD/USD rate in all Friday closing within 10/04/09 to 12/29/09.

Long Average or Long Asian

Payoff

Underlying
price

Premium
X1

Payoff

Scenario 1 Weekly average price of Spot fixing is bigger than the strike 0.8600 ( X1 ), Long Call
average option can be exercised and you can buy AUD/USD at strike 0.8600 ( X1 ).

Scenario 2 the average price of Spot fixing is below the strike 0.8600 ( X1 ), Long Call average
option expires worthless. You lose the premium AUD 21,570.

Average Strike Asian option

Average Strike Asian option is another Average option but with the Strike is not fixed at
the beginning. Average strike option is also similar to a vanilla option, but the strike is
determined at expiration as an average of the Spot prices fixings during the life of option.
28. Fader Option
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Fader is a regular vanilla option where the notional is determined on the expiry date rather than a
pre-determined value. At expiration the exact notional depends on all of the following combined :

(a) Pre-defined spot condition :

This can be set as a range, where the Spot must be inside or outside the range, or as a one-sided
condition, where the Spot is above or below a pre-determined trigger.
(b) Number of fixings on which the pre-determined spot condition is met.
(c) Total number of fixings
(d) Type of fader to choose

Fade-in option
each time the spot condition is met on a fixing date, a proportion of the option’s notional is
accumulate or fade-in (i.e. the final notional increases). The notional is = n/N × Notional on
maturity.
where n is the number of fade-in
N is the total number fixing days in the option life,
Notional is the maximum notional amount set in the fader option,

Fade-out option
each time the spot condition is met on a fixing date, a proportion of the option’s notional is
faded out or deducted from the maximum that could have been included in the option’s total
notional amount at expiry (i.e. the predefined notional decreases). That is, on expiry date the
notional is = Notional – ( n/N × Notional ),
where n is the number of fade-out over the life of option
N is the total number fixing days in the option life,
Notional is the maximum notional amount set in the fader option,

Fader option is an option where the notional accumulates according to a certain condition on FX
but the exercise decision is made at maturity. For example, if I have a daily Fade-in Call at strike
105 for daily cumulative amount U$ 1,000 on condition USD/JPY is greater than 100 and the tenor
of the option 90 days, I will accumulate U$1,000 × N for days USD/JPY is over 100; and I hold a
Call option for Notional ( U$1,000× N ) to buy at USD/JPY at 105. This option will be cheaper
than buying a vanilla Call with strike 105 for the whole Notional.

Payoff

Fade in Call = N × ( ST – XC )
Fade in Put = N × ( XP – ST )
Fade out Call = ( Notional – N ) ( ST – XC )
Fade out Put = ( Notional – N ) (XP – ST )
where ST is the spot value at expiry
N is the sum of notional accrued = ∑ Ni ( if Si is in trigger region, zero otherwise ) ,
Si is the value of the Spot rate at time Ti .
Player strategy

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Fader buyers have directional views on the spot rate movement. They want to benefit from the
favourable market movement at low cost. The cost of Fader is less then vanilla option given similar
condition. The premium is reduced because there is always the possibility that the spot will move
against you, leaving you with an unhedged FX exposure risk.

29. Range Accrual

FX Daily Range Accrual note accrues an enhanced yield on each business day providing that
reference FX spot rate fixes within a predefined range. For each day that the reference FX spot rate
fixes outside the predefined range, the note accrues at a prescribed minimum yield (or zero most
likely). Any accrued interest is paid on the periodic interest payment dates typically monthly,
quarterly, semi-annually, or even at the end of investment period. FX daily Range Accrual notes
are principal protected.

FX Range Accrual note has notional grows with each fixing date given that the Spot is within the
trigger level or range. The higher the FX volatility, the higher the yield enhancement and wider
range.

Payoff

Range Accrual Note = N

where N is the sum of notional accrued = ∑ Ni ( if Si is in trigger region, zero otherwise ),
Si is the value of the Spot rate at time Ti .

Digital Range Accrual

Digital Accrual is a contingent cash payment that the amount of payment depends on the value of
Spot at multiple fixings. Digital Range Accrual note has notional grows with each fixing date then
make payment providing the Spot within the trigger level or range.

The accrual range is typically set above and below the Spot. The further the outright FX forward
rate is away from Spot, the higher the probability of the boundaries being exceeded and hence a
greater potential yield enhancement or wider range. Similarly, the higher the FX volatility, the
higher the yield enhancement and wider range.

Payoff

Call option = N, if ST ≥ XC, or zero otherwise

Put option = N, if ST ≤ XP, or zero otherwise
where ST is the Spot rate at expiry
N is the sum of notional accrued = ∑ Ni ( if Si is in trigger region, zero otherwise ),
where Si is the value of the Spot rate at time Ti .
Figure 93. AUD<Crncy> OVML DACCR<GO>

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Figure 93 shows a 1year AUD/USD Digital Accrual with strike 0.8800 valid from 10/07/09 to
09/28/10. You can exercise option and buy

AUD5.2mio × (number of days that Spot rate is within the Lower and Upper barrier range)
The total number of days in the life option

at 0.8800.

Player strategy

Range Accrual note is a principal guaranteed note or a minimum guaranteed note, that enables note
holders to potentially earn an enhanced yield based on a view of FX rates movement in the future
at very risk. Most of the note holders buy Range Accrual as a directional investment in FX market
rather than hedging instrument.

However, the risk to note holders is that Spot rate fixes consistently outside the accrual range. If
this occurs for the entire period, holders will receive only a minimum guaranteed return.

Partial Accrual
Partial accrual is possible where the Accrual stops completely once a range boundary is
broken, but all previous interest accruals are kept.

Quanto Range Accrual

Range Accrual can be in Quanto form, where the Range Accrual occurs based on a currency
pair that is different from the denomination of Range Accrual note and payoff.
For example, Range Accrual note settles in EUR-cash but accrues on USD/IDR fixings.

30. FX Accumulator

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FX Accumulator is a forward where the notional depends on the Spot rate to a series of fixings.
The initial notional amount of the option is zero and the maximum notional amount is negotiable
between buyer and writer.

If Spot lies within the trigger range or level at each fixing date, the notional growths by the
accumulation amount. The accumulation amount is the maximum notional divided by the number
of fixings.

FX accumulator is constructed by a strip of single-leg or multi-leg FX options. The major benefit

of FX Accumulator, or strip options, is the spreading of the option payoffs over a period of time,
instead of concentrating the payoff on a single expiry date.

Payoff

N × ( ST – X )
where X is the strike or FX forward in the contract
ST is the Spot rate at expiry
N is the sum of notional accrued = ∑ Ni ( if Si is in trigger region, zero otherwise )
Si is the value of the Spot time Ti .

Figure 94. AUD<Crncy> OVML ACCU<GO>

Figure 94 shows a 1year AUD/USD Weekly Accumulator with notional AUD 5,200,000 and strike
at 0.8800 valid from 10/07/09 to expiry 10/05/10.
Scenario 1 the FX rate is outside the range (0.85 – 0.91) during this 1 year. The number of Accruals
week is zero. You lose premium AUD 40,538.

Scenario 2 the FX rate has n weeks that stay within the Lower (0.8500) and Upper (0.9100) barriers,
you can buy AUD notional 5,200,000×n/52 at strike 0.8800 at maturity.

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Scenario 3 FX rate is range trading within the range (0.85 – 0.91) for the whole year, number of
weeks within the range is 52 that is same as the total number of week in a year. So, you can buy
AUD 5,200,000 at strike 0.88 on maturity day.

Player strategy

FX accumulator is another very popular FX option strategy seen in private banking, and PB clients
like to investor into FX structure in order to earn from directional trade with low cost. Compare to
FX forward, FX Accumulator consists of gearing with lower risk and no margin requirement.

Strips
Strip is a portfolio of similar options with different expiration dates, that can be added to
one-period option such as vanilla option, Collar, Risk Reversal and Participating forward;
but Strips cannot be added to a multi-period option, e.g. a calendar spread.

To set up Strips in {OVML<GO>}, after an option is created, click in red toolbar, go to ’91)
Actions’ and click on ‘Generate Strip’. Enter number of desired periods in ‘Striplets’ .

For example a 3Month option with 3 strips, it will be 3 options combination, each option
maturity is :
1) Now to 1Month,
2) 1Month to 2Month,
3) 2Month to 3Month.
We can set individual strikes for each strips. So, even though first option is exercised, the
2nd and 3rd options are still existing.

Figure 95. Six monthly Striplet in OVML<GO>

Player strategy: For some companies, a single hedge every year that covers prejected
foreign revenue may suffice, but they are better to enter into a serires of transactions times
to correstpond with monthly cashflow. The simplest method is to setup a Strip of monthly
structures.
Compound
Compound option is one where the underlying asset is another option. Examples of compound
option are a Call on Call and a Call on Put. This option would give the option holder the right to

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buy the underlying call at a fixed price at some point in the future if the option was ITM.
Alternatively, if the premium on the underlying Call is greater than the Compound option’s strike.

Player strategy

Compound option is an exotic option, most of the players are professional traders.

31. Risk Management

The Net Option Values area of the screen will display Greeks and prices for the net options position.
You can enter in custom prices and premiums in the yellow fields.

For non-spread strategies (i.e. buying or selling all the legs) the premium will always be
positive and a tooltip will display whether the premium is paid or received.

For spread strategies (i.e. a mix of buying/selling across all legs) the premium will be signed
so that the premium to be received will be a positive amount and the premium paid will be a
negative amount.

Figure 96. Net Values screen in OVML<GO>

FX option analysis

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To analyze the risk and P/L of these options, you need to save the deal in {OVML<GO>} then
book deals into portfolio {PRTU<GO>}. After all, you can run {OVRA<GO>} on that portfolio
for scenario analysis on FX option in portfolio.

Figure 97. OVRA<GO>

{OVRA<GO>} is used to display and manage risk of your FX options and forwards portfolio

▪ A/E indicates American or European exercise style.

▪ Ccy 1 is the option’s notional amount, expressed in term of the base currency, which is the
first currency in the currency pair.
▪ Ccy 2 is the option’s notional amount, expressed in terms of the commodity currency, which
is the second currency in the currency pair.
▪ Cost Ccy 1 is the option’s premium amount, expressed in terms of the base currency, which
is the first currency in the currency pair. The premium amount is calculated using the current
exchange rate.
▪ Expiry Rate is the spot rate used for exercise of the option at the expiration date. Generally,
the spot rate that appears in the Exercise or Expire option Trades window is used as the expiry
rate.
▪ Exp P/L Ccy1 is the profit and loss of the trade in Currency 1 at the time it was exercised.
Determined by calculating the difference between the value of the option at expiration and
the cost of the option converted to Currency 1.
▪ Exp Val Ccy1 is the value of the option at expiry expressed in Currency1 at the time of
expiration.
▪ Forward is the market forward rate for the selected currency pair.
▪ P/C indicates Put / Call option.
▪ P/C Ccy is the currency code of the base/commodity currency in which the option appears as
a Call/Put. The Country or Currency Codes section of this guide displays further information.
▪ Prem Paid is the price paid for the option.
▪ Prem Ccy is the currency code of the base/commodity currency in which the price of the
option appears. The Country or Currency Codes section of this guide displays further
information.
▪ Status is the status of the option. Statuses are as follows:
- Active
- Exercised
- Exercise

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 - Expired

▪ Value Ccy1 is the option's current market value, expressed in terms of the base currency,
which is the first currency in the currency pair.

*HINT*
* Options in the portfolio that have not been expired or exercised are marked as Active.
* All exercised options at expiration date are marked as 'Exercised'.
* All expired options at expiration date are marked as 'Expired'.
* All new Cash and FX trades generated as a result of the what-if auto expiry are marked as
Exercise.

Greeks

Delta : Dollar value change in option price given $1 change in price of underlying.
When underlying price rises, Call (delta) > 0, but Put (delta) < 0.

Deltacall δC = e-D(T-t) N(d1) DeltaPut δP = e-D(T-t) [N(d1) -1]

δU δU

In {OVRA<GO>}, that is Pos Delta1: The option's position Delta, expressed in terms of
the base currency, which is the first currency in the currency pair.

Figure 98. Delta in OVML<GO>

Gamma : Amount change in Delta as the price of underlying changes $1

Gammacall = δDeltacall GammaPut = δDeltaPut

δU δU

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Gamma = e-D(T-t) N’(d1)
= σ S √(T-t)

Figure 99. Gamma in OVML<GO>

Vega : Value change in option price given 1% change in volatility

VegaCall δC = U√t N’(d1) VegaPut δP = U√t N’(d1)

δσ δσ

Vega = S √(T-t) e-D(T-t) N’(d1)

In {OVRA<GO>}, Vega Ccy1 : The change in the option's price, expressed in terms of the
base currency, for a 1% change in volatility.

Figure 100. Vega in OVML<GO>

Theta : Dollar value of option price changes as time decay is calculated over 1 day. As
time passes, price declines.

ThetaCall ∂ C = - UN’(d1)σ ThetaPut ∂ P = - UN’(d1)σ

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 ∂t 2√t ∂t 2√t

In {OVRA<GO>} Theta Ccy1 : The change in the option's price over time, expressed in
terms of the base currency, which is the first currency in the currency pair.

Rho : Sensitivity of option premium to 1% move in risk-free-rate

RhoCall ∂ C = - X t e-rt N(d2) RhoPut ∂ P = - X t e-rt N(-d2)

∂r ∂r

Volga : Change of Vega for 1% change in volatility

Volga = S √(T-t) [- e-D(T-t) N’(d1) ] d1 d2

σ
In {OVRA<GO>} Volga Ccy1: The change in the option's Vega when the base currency
volatility changes. The base currency is the first currency in the currency pair.

Vanna : Sensitivity of Vega to changes in underlying price.

Vanna = - e-D(T-t) N’(d1) d2

σ
In {OVRA<GO>} Vanna Ccy1 : The change in the option's Vega when the base currency
spot value changes.

All the above formulas are for European option only.

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