Section Three

Currency Derivatives
Contents:

 What is Currency Derivative?

 Forward Market,
 Currency Futures Market,
 Forward versus Futures Markets,
 Currency Options Markets: Call and Put Options,
 Factors Affecting Option Premium,
 European Currency Options.

Learning Objectives:

I. To explain how forward contracts are used for hedging based on anticipated
exchange rate movements; and
II. To explain how currency futures contracts and currency options contracts are used
for hedging or speculation based on anticipated exchange rate movements.

Introduction

Currency derivative is a financial product/financial assets/financial contract which is used

by hedger for hedging exchange rate risk.

TERMS
Exchange rate risk is the variability in exchange rates due to different factors like change
in real rate/change in inflation rate/change in interest rate/change in growth of GDP, etc.
Currency refers to local (Taka) and foreign currency( Rupee/Dollar/Euro/Pound, etc.)
Derivative- is a financial assets (developed by financial engineer) or financial contract
profit or loss on which depends/can be derived on the likely movement in price of assets
underlying the contract.
Hedging- is a method of managing price risk.

Hedger-The person or firm who transfers risk from his side to counterparty side.

Hedging means closing position and lock in price through hedging tools.

 Long-Buyer takes long position in the contract; and

 Short-Seller takes short position in the contract.
Currency Derivatives-Definition

Currency derivative

1. is a contract/financial assets
2. between two or three parties
3. that facilitates buying and selling
4. specific currency underlying the contract
5. at a pre-fixed exchange rate
6. on a certain date in the future and
7. profit or loss on which can be derived depending on the movement in exchange rate in
the future.

Currency derivatives are financial contracts (forward, futures, options and swaps) which have no
value of their own. They derive their value from the value of the underlying asset, in this case,
currencies. For example, assume that the current USD/INR rate is 73.2450. A 1 month USD/INR
futures contract is trading at Rs 73.3650.Here, the underlying asset is the USD/INR exchange
rate and the 1 month futures contract being traded is the currency derivative. The underlying
asset and the derivatives contract have different values. But the value of the derivative is
dependent and derived from the value of the USD/INR current exchange rate.

What are Currency Derivatives?

There are four major currency derivatives:

1. Forward Contract on Foreign Currency;- Forward Market-OTC Market

2. Currency Futures;- Futures Market-Organized Market
3. Currency Option; and –Option Market-OTC and Organized Market
4. Currency Swap.-Swap Market-Organized and OTC Market

Currency derivatives are contracts to buy or sell currencies at a future date. The major types of
currency derivatives are forward contracts, futures contracts, options and swaps. Despite having
an average daily turnover of Rs 44,859 crores, currency derivatives in India are largely unknown
to small retail investors. The currency derivatives trading segment in India is dominated by
importers, exporters, central banks, banks and corporations. While currency derivatives in India
are primarily used for hedging, retail investors can create wealth in the currency derivatives
segment by speculating and arbitraging.
Forward Market-Development

 In 1840s, Chicago, USA : Farmers produced bulk size of agro-products; but could not
sell because of
Demand<<<<<<<<<supply;
No effort of Government to buy;
Poor communication between states;
 Besides, they could not store the bulk quantity of products due to lack of Godown.
 As a result, they incurred huge amount of loss.
 In 1844, Chicago , USA: A group of businessmen met together to resolve this problem.
Finally, they came out with a decision to standardize products and establish of market.
So, they established Chicago Board of Trade (CBOT).
 1844-1920: Many forward markets on eggs/rice/wheat/foreign currency were
developed.
 In 1920, they standardized contract and enhance the quality of grains. For doing so,
they developed a clearing House for establishment of Futures Market-Organized.

The forward market facilitates the trading of forward contracts on currencies.

Forward Market and Forward Contract

Forward contract
 is a financial assets/financial product
 between two parties-Buyer and Seller
 that facilitates buying and selling -Liquidity
 a particular assets underlying the contract
 at a pre-fixed price
 on a certain date in the futures.-last day of contract.

Features of Forward contract:

Forward contract
1. is a financial assets/financial product
2. involves two parties-Buyer and Seller (Principals)
3. facilitates buying and selling -Liquidity
4. There is a particular assets underlying the contract
5. Pre-fixes price- strike Price/contractual price/delivery price;
6. on a certain date in the futures.-last day of contract.
7. Is a product of over-the-counter market;
8. This involves :
I. No third party;
II. No commission; and
 III. No margin.
9. This is non-standardized product;
10. The initial value of the forward contract is always zero.

A forward contract is an agreement between a corporation and a commercial bank to

exchange a specified amount of a currency at a specified exchange rate (called the forward
rate) on a specified date in the future.

When MNCs anticipate future need or future receipt of a foreign currency, they
can set up forward contracts to lock in the exchange rate.

Forward contracts are often valued at $1 million or more, and are not normally
used by consumers or small firms.

When MNCs anticipate future need or future receipt of a foreign currency, they
can set up forward contracts to lock in the exchange rate.

Forward contracts are often valued at $1 million or more, and are not normally
used by consumers or small firms

What are the uses of Currency Derivatives in India?

Currency derivatives in India are primarily used for:

 Hedging: By importers / exporters and other hedgers

 Speculating: By speculative traders
 Arbitraging: By arbitrage traders

Development of Forward Market

Evolution

 There is a doubt where this market was basically developed.

 Asia claimed that this market was developed in India;
Dadan/Forward Sale/Sale on Due. But there is no documentary
produced as of today in favor of claim.
  USA has claimed and shown documentary evidence in develoing
forward market in Chicago.
How?

In 1840s: Farmers in Chicago had produced bulk size of agro products; but
made a huge amount of losses for

 Demand < Supply;

 No international trade/export;
 No government purchase;
 No storage facility;
 No market for forward sale;
 No Go down of Government;
 No society for accommodation
 Communication (Road/Sea/Air) was almost non-existent.
Farmers could not sell the huge quantity of agro products in these years. They
had thrown all the unsold agro products at sea. This had caused a huge amount
of loss.

In 1846: A group of businessmen met together in order to solve this problem of

farmers and developing business.

 They undertook an effort for standardizing contract and quality of

grains;
 They made an effort for developing business houses for selling goods
forward or well ahead of harvesting products:
 Finally, they established ‘Chicago Produce House’
 Then, Chicgo Butter House;
 Then, Chicago Egg House;
 Then Chacago Mercantile Exchange;
In 1920: Businessmen had undertaken an effort for developing a “Clearing
House” through standardization of contract for initiating an organized market
for Futures.

This is how, finally future market was developed also in USA.

Forward:

Forward is a contract/financial assets between two parties to facilitate buying

and selling a particular assets at a pre-fixed price on a certain date in the future.

Features of Forward Contract

 Forward is a contract/financial assets –This is a financial derivative.

 between two parties –Buyer and Sellers(principals)
 to facilitate buying and selling-Liquidity-Converting assets underlying into
cash
 a particular assets-assets underlying the contract-financial assets/Real
Assets
 at a pre-fixed price /Strike Price (K)/ Contractual price/Delivery
Price( This price is fixed on the day of signing contract and be effective for
purchase of assets underlying the contract.)
 on a certain date in the future.-last day of contract;
 the forward contract is executed/settled on the last day of contract.
 Besides, the forward contract has also some distinct features as follows:
 This is a product of OTC Market;
 This is a non-standardized market;
 Non-standardized implies-
The product/contract of this market is non-standardized.
That is,
This market does not involve third party/brokers/
This involves no commission/
This involves no margin;
he contract can be customized.
 The forward price is the strike price of the forward contract;
 This locks price and
 This closes position –long and short of the parties involved; and
 This is to mandatorily executed by both the parties i.e. Parties can’t
escape from buying or selling i.e. the forward contract generate
obligations for the principals as soon as the contract is signed.
Forward Contract:

Forward contract can be classified into two:

Forward Contract on Forward Contract on

Financial Assets Consumption Assets

Definition Do Do

Assets Foreign Currency, Oil,

Underlyin Equity Shares Agro
g Bonds-Corporate Products-Paddy/Wheat/
Bond/Treasury Spices
Bonds Cows/Buffalos/
Assets Backed Living Hogs
Securities, Etc.
Commercial Papers
Banker’s Acceptance

Pricing of Forward Contract: Factors

Is a technique of /estimating/ forecasting forward price/future price/forward

spot price of a particular asset underlying a contract.

Three Factors:

1. So= Spot Market Price-The price prevailing in the market on the day of
signing contract.
2. T =Terms of contract=Holding Period/Contractual Period (t for times
expressed in terms of year);
3. r = Risk Free Rate /Discount Rate/Compound Rate
4. Other factors are:
  So = Spot Price of Alternative Products;
Carrying Cost
Dividends/Interest to be received or paid.
Note that interest is always compounded continuously.

Forward Contract-Pricing and Valuation

If assets Forward Contract on Forward Contract on

underlying Financial Assets Consumption Assets
the forward
contract
offers:

I. No dividend I. If consumpition assets

during Fo= 35 (2.718) ❑0.07∗0.50 underlying the
contractual = Tk. 36.25 forward contract
Period Where, involves no cost to
(Non- Fo= Forward Price carry:
dividend So= Spot Market
paying Price;Tk. 35 Fo= Forward Price
assets/stock e = 2.718;
) r =Risk free Rate;7%
t = Terms to Forward
Contract, 6/12= 0.50
year

II. Lum-sum Fo=(S o−Do)e

rt
II.If consumption
dividend Fo= (Tk.35- Tk.1.47) assets underlying the
(0.07∗0.50)
during the 2.718 forward contract
contractual Fo= Tk.34.72 involve cost to carry:
period Where,
D4=Dividend Per Fo=(So +Co)e
rt

Share at the end of Where,

four months, Tk. 1.50 Co=Carrying Cost Per
 Do= Dt e−(rt ) Unit
Do= Dt / e (rt ) ; Do=
Tk.1.47
Dividend Per Share
( r−q ) t
III. Dividend in F 0=So e
proportion Fo= Tk.35 .
( .07−0.015 ) ∗.50
to the price 2.718
Q= rate of dividend,
15%

Note that interest is always compounded on continuous basis.

rt
Fo=(So−Do)e
rt
Fo=(So +Co)e

Valuation of Forward Contract:

CASE ONE:
 The value of Forward Contract on the day of signing contract = Zero
 Why? Because, Both forward price (Fo) and Strike Price (K) will be equal
or the same on the day of signing contract. For example

Position-Long Position Short

(Buy) (Sale)

Initial Value of V 0=(So−K )e

r .t
V 0=(K−So)e
r .t
 Forward
Contract (Vo)

Fo/So=Forward
Price or Spot Price
on the day signing
Contract
K=Contractual or
Strike Price

CASE TWO:

Value of forward contract would be zero or other than zero after the day of
signing contract.

 Why? Strike Price/Contractual Price/Delivery Price (K) will remain the

same or will not change during contractual period; but forwTheard
price /future spot price(Fo/St) will change during the contractual priod.

Arbitrage Opportunity in Forward Market

Arbitrage is the simultaneous buy and sale of the same assets at two
different price from /to different markets with a view to make risk
free profit/arbitrage profit.

Arbitrage is the process of

 buying at low price and

 selling at high price, and
 thereby making arbitrage profit.
 Case I Case-II Case-III

So=Tk 34 So=Tk.36 So=Tk. 38

Required: Required: Required:
a) K= k.36.25 aK= k.36.25 a) K= k.36.25
b) K=Tk 34.74 b) K=Tk 34.74 b) K=Tk 34.74
c) K=Tk. d) K=Tk c) K=Tk.
Fo = K Fo > K Fo < K

Is there any No Yes Yes

arbitrage
opportunity
?

How to N/A In this case, In this case,

make Arbitrageur Arbitrageur
arbitrage will buy at K will buy at
Profit? (through Fo (from
contract) the market
taking long at low
position; and price) and
sell at Fo(high sell at k
Pirce) in the (high Price)
market. This is through
how, he/she contract.
can make This is how,
arbitrage or he/she can
risk free profit. make
arbitrage or
risk free
profit.
Practices: Exercises-Forward Contract on Foreign Currency
1. Lever Brothers Limited is required to pay $100,000 to the Exporter-Exxon Limited,
USA for importing goods after two months. The CFO is contemplating the volatility
of exchange rate in the coming months. To hedge the foreign currency risk, it has
entered into a contract with Sonali Bank Limited for buying $ 100,000 at a
contractual price of $ 1 = Tk. 86.50 after two months.
Show what would be profit or loss on forward contract if spot exchange rate at the
end of two months is expected to be:
Tk. 86.00, 86.25, 86.50, 86.75, or 87.00

Strike Price(ko) = $1 = Tk. 86.50

Table: Calculation of Profit or loss on Forward Contract

Spot Strike Rate Lever Brothers Sonali Bank Limited

Exchange of Exchange Profit(Loss) =(So-Ko)NOC× Profit (loss)= (Ko - So)NOC
Rate (So) ($) (Ko) ($ 1) Volume × Volume
Tk 86.00 Tk. 86.50 (Tk. 86 –Tk.86.50) (Tk. (Tk. 86.50 – Tk.
1 × $100,000 50,000) Tk.86.00) 1 × 50,000
$100,000
Tk 86.25 Tk. 86.50 (Tk. 86.25 – (25,000) (Tk. 86.50 – 25,000
Tk.86.50) 1 × Tk.86.25) 1 ×
$100,000 $100,000
Tk 86.50 Tk. 86.50 (Tk. 86.50 – 00 (Tk. 86.50 – 00
Tk.86.50) 1 × Tk.86.50) 1 ×
$100,000 $100,000
Tk 86.75 Tk. 86.50 (Tk. 86.75 – 25,000 (Tk. 86.50 – (25,000)
Tk.86.50) 1 × Tk.86.75) 1 ×
$100,000 $100,000
Tk 87.00 Tk. 86.50 (Tk. 87 –Tk.86.50) 50,000 (Tk. 86.50 – 50,000
1 × $100,000 Tk.86.00) 1 ×
$100,000

Figure: Showing Profit or Loss on Forward Contract

Futures Market

 is an organized market.
 Bring three parties to the network: Broker for buyer, Broker
for seller, and Clearing House Agent;
 Facilitates trading of financial assets including foreign
currency and real assets like commodities between parties.
 Performs all functions of a market specifically, liquidity,
efficiency, continuity and sensitivity.

Futures Contract

 Futures is a contract
 Between three parties- Broker for buyer, Broker for Seller,
and Clearing House Agent
 That facilitates buying and selling
 An assets underlying the contract-Financial
assets/Commodities, etc
 At a prefixed price –Fair Price to be fixed on the day of signing
contract
 On a certain day as is fixed by the exchange.

Besides, this being a standardized contract involves

 Third Party unlike forward

 Margin Requirement
 Adjustment of closing price through margin
  Commission
 If not executed on the day as is fixed contract is ceased.

Introduction

Standardization of contract and establishment of clearing house had

facilitated introduction of futures market in 1920. The first Stock Index
Future contract based on a value line index was introduced by the KCBT
(Kansas City Broad of Trade) on 24th febraury,1982. It was followed 2
months later by the S&P 500 index futures contract introduced by the
Chicago Mercantile Exchange (CME).At present an S&P 500 index future is
the most actively futures contract in the world.

This came into being in India with the recommendation of the L.C Gupta
committee report on Financial derivation. The report was instrumental for
the launching of many of the derivative Products In the India capital market
way back in May 1998.‘Stock Index Future’ was one of the important
products of derivatives introduced by the two pioneering stock exchanges in
India the Bombay stock Exchange and the National Stock Exchange on 9th
June and 12th June 2000 respectively.

In Bangladesh, there exists no derivative market as of today. BSEC, CSE and

DSE have undertaken an initiative at least to introduce stock index futures
and option on stock index. In view of this, they have taken programs for
educating related personnel of the market and promulgation of relevant laws
and legal infrastructure. The Government is actively considering bringing a
bill for introducing derivative market in the Member of Parliament.

Distinguish between Forward Contract and Futures Contract

 Forward Contract Futures Contract
A forward contract is an agreement A futures contract is a standardized
between two parties to buy or sell an contract, traded on a futures exchange, to
Definition asset (which can be of any kind) at a buy or sell a certain underlying
pre-agreed future point in time at a instrument at a certain date in the future,
specified price. at a specified price.
Customized to customer needs.
Structure & Standardized. Initial margin payment
Usually no initial payment required.
Purpose required. Usually used for speculation.
Usually used for hedging.
Transaction Negotiated directly by the buyer and
Quoted and traded on the Exchange
method seller
Government regulated market (the
Market Commodity Futures Trading
Not regulated
regulation Commission or CFTC is the governing
body)
Institutional Clearing House-is an adjunct to the
The contracting parties
guarantee exchange.
Risk High counterparty risk Low counterparty risk
No guarantee of settlement until the Both parties must deposit an initial
date of maturity only the forward price, guarantee (margin). The value of the
Guarantees
based on the spot price of the operation is marked to market rates with
underlying asset is paid daily settlement of profits and losses.
Contract Forward contracts generally mature by Future contracts may not necessarily
Maturity delivering the commodity. mature by delivery of commodity.
Expiry date Depending on the transaction Standardized
Opposite contract with same or
Method of pre- different counterparty. Counterparty
Opposite contract on the exchange.
termination risk remains while terminating with
different counterparty.
Depending on the transaction and the
Contract size Standardized
requirements of the contracting parties.
Market Primary & Secondary Primary

Futures: Classification
1. Financial Futures 2. Commodity
 Currency Stock Index Interest Rate Futures
Futures Futures Futures
Definition
Assets Underlying All Stock Indices Tresury Bill. Spices,
currencies being an Treasury
of the world underlying Bond, Oil,
assets
Dollar, Corporate Rice,
Pound CSE-30 Bond
Jute,
Euro S & P-500 Corporate
Debentures Wheat,
Rupee DJIA-50
Assets Living Hogs
Ringit Backed
Securities Fish etc.

Characteristics of Futures Trading:

“Futures Contract” is a highly standardized contract with certain distinct

features. Some of the important features are as under :

a) Futures’ trading is necessarily organized under the auspices of a market

association so that such trading is confined to or conducted through
members of the association in accordance with the procedure laid down
in the Rules & Bye-laws of the association.

b) It is invariably entered into for a standard variety known as the "basis

variety" with permission to deliver other identified varieties known as
"tenderable varieties".

Basis Point: 50 Basis Point i.e. 0. 50%

c) The units of price quotation and trading are fixed in these contracts ,
parties to the contracts not being capable of altering these units.
d) The delivery periods are specified.
e) The seller in a futures market has the choice to decide whether to
deliver goods against outstanding sale contracts. In case he decides to
deliver goods, he can do so not only at the location of the Association
 through which trading is organized but also at a number of other pre-
specified delivery centres.
In futures market actual delivery of goods takes place only in a very few
cases. Transactions are mostly squared up before the due date of the
contract and contracts are settled by payment of differences without
any physical delivery of goods taking place

 Currency Options Markets: Call and Put Options,

 Factors Affecting Option Premium,
 European Currency Options.

Development of Currency Option Market

Currency Option Market is one of the components of option market.

Option Market

Many people think of options trading is a relatively new form of investment when compared to
other more traditional forms such as buying stocks and shares. The modern options
contracts as we know them were only really introduced when the Chicago
Board of Options Exchange (CBOE) was formed, but the basic concept of
options contracts is believed to have been established in Ancient Greece:
possibly as long ago as the mid fourth century BC.

Since that time options have been around in one form or another in various marketplaces, right
up until the formation of the CBOE in 1973, when they were properly standardized for the first
time and options trading gained some credibility. On this page we provide details on the history
of options and options trading, starting with Ancient Greece and going right through until the
modern day.

 Thales and the Olive Harvest

 Tulip Mania in the 17th Century
 Bans on Options Trading
 Russell Sage and Put & Call Brokers
 The Listed Options Market
 Continued Evolution of Options Trading
When the CBOE first opened for trading, there were very few contracts listed, and they were
only calls because, puts hadn't been standardized at this point. There was also still some
resistance to the idea of trading options, largely down to difficulties in determining whether they
represented good value for money or not.

The lack of an obvious method for calculating a fair price of an option combined with wide
spreads meant that the market was still lacking in liquidity. Another significant development
helped to change that just a short time after the CBOE was opened for trading.

In that same year, 1973, two professors, Fisher Black and Myron Scholes, conceived a
mathematical formula that could calculate the price of an option using specified variables. This
formula became known as the Black Scholes Pricing Model, and it had a major impact as
investors began to feel more comfortable trading options.

By 1974 the average daily volume of contracts exchanged on the CBOE was over 20,000 and in
1975 two more options trading floors were opened in America. In 1977, the number of stocks on
which options could be traded was increased and puts were also introduced to the exchanges. In
the following years, more options exchanges were established around the world and the range of
contracts that could be traded continued to grow.

Towards the end of the 20th century, online trading began to gain popularity, which made the
trading of many different financial instruments vastly more accessible for members of the public
all over the world. The amount and quality of the online brokers available on the web increased
and online options trading became popular with a huge number of professional and amateur
traders.

In the modern options market there are thousands of contracts listed on the exchanges and many
Onhows no signs of slowing down.

Fundamentals-Option

Option is a hedging product.

Option is a contract.

Option is a strategy for hedging risk and making profit.

Option can be traded on Organized Market and OTC Market.

Options trading may seem overwhelming at first, but it's easy to understand if you know a few
key points. Investor portfolios are usually constructed with several asset classes. These may be
stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used
correctly, they offer many advantages that trading stocks and ETFs alone cannot.
Options are powerful because they can enhance an individual’s portfolio. They do this through
added income, protection, and even leverage. Depending on the situation, there is usually an
option scenario appropriate for an investor’s goal. A popular example would be using options as
an effective hedge against a declining stock market to limit downside losses. Options can also be
used to generate recurring income. Additionally, they are often used for speculative purposes
such as wagering on the direction of a stock.

In 1982, Many exchanges in USA have allowed for trading of standardized currency
options.

Option-Definition

Option –Definition, Classification and Types

 Option is a contract/financial assets/Hedging product

 Between two parties-Option buyer and option seller;
 Which provides right (buy or sale right; not obligations) to the option buyer
against payment of premium to the option seller
 To buy or sell -Liquidity
 A particular assets –Underlying assets- Share/bond/debenture/foreign
currency, etc.
 At a prefixed price/conctractual price/delivery price/Strike Price (K);
 On a certain date/day in the future.-last Day of contract.

Currency Put Option

 is a contract
 between option buyer and option seller
 which provides right to the option buyer against payment of premium to the
seller;
 to sell a particular currency for another currency
 at a prefixed exchange rate/strike price/contractual price (k )
 on a certain date/last day of contract; or on any day of the contractual
period.
Option Types-European Option and American Option

Parties to the currency option:

1. currency option buyer-buys right to buy or sell currencies against payment

of premium to option seller;
2. Currency option seller, and Currency option writer.-receives premium
and provides right to option buyer to buy or sale currency;

Option-Classification
Call Option-to Buy Put Option-To Sell
 Option is a contract/financial  Option is a contract/financial
assets/Hedging product assets/Hedging product
 Between two parties-Option  Between two parties-Option
buyer and option seller; buyer and option seller;
 Which provides right to buy to  Which provides right to sell to
the option buyer against payment the option buyer against payment
of premium to the option seller of premium to the option seller
 To buy or sell -Liquidity  To buy or sell -Liquidity
 A particular assets –Underlying  A particular assets –Underlying
assets- assets-
Share/bond/debenture/foreign Share/bond/debenture/foreign
currency, etc. currency, etc.
 At a prefixed price/conctractual  At a prefixed price/conctractual
price/delivery price/Strike Price price/delivery price/Strike Price
(K); (K);
 On a certain date/day in the  On a certain date/day in the
future.-last Day of contract. future.-last Day of contract.
 Option-Types
European Option American Option
This allows option buyer to exercise This allows option buyer to exercise
option right on the last day of contract. right on any of the contractual period.
This is why, premium on option is This is why, premium on option is
lower. higher.

Option is a right not obligation;

Option works like insurance. Option buyer buys/sells/exercises option if there is a
profit.
Parties to the Option
Option Buyer Option seller/Option writer
Option buyer pays premium to the Option seller sells right to option buyer
option Seller/writer. against receipt of premium of buying or
Against this payment, option buyer selling a particular assets.
receives/enjoys right to buy or to sell a
particular assets.

Features of Currency Option

F1: Currency Option is a contract/financial assets/Hedging product;

F2: This involes two parties:-Option buyer and option seller;
F3: This provides right (buy or sale right; not obligations) to the option buyer
against payment of premium to the option seller
F4: To buy or sell -Liquidity
F5: There is an asset underlying the contract;-Specific currency
F6: This fixes price on the day of signing contract; contractual price/delivery
price/Strike Price (K);
F6: The contract will be executed/settled on the last day of contract if it is
European currency option; or on any day of the contractual period if it is
American Currency Option;
 F7: This lock position in the contract-Long and Short;
F8: Option buyer will exercise contract on the last day of contract if there is a
profit or positive ending value.
F9: Option will expire on the last day of contract if option buyer does exercise
option.
F10: Option is a right of the option buyer ; not obligations; and
F11: Currency Option Seller is obliged to buy or sell if currency option buyer
exercises option; and
F12: Currency option buyer cannot forced to exercise option; and
F13: Currency option may be traded in both organized and OTC market.

Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount
of some underlying asset at a pre-determined price at or before the contract expires. Options can be
purchased like most other asset classes with brokerage investment accounts.

Option-Types

Option can be of two types: Call Option and Put Option. A call option gives the holder the right
to buy a stock and a put option gives the holder the right to sell a stock.

American and European Options: American options can be exercised at any time between
the date of purchase and the expiration date. European options are different from American
options in that they can only be exercised at the end of their lives on their expiration date. The
distinction between American and European options has nothing to do with geography, only with
early exercise. Many options on stock indexes are of the European type. Because the right to
exercise early has some value, an American option typically carries a higher premium than an
otherwise identical European option. This is because the early exercise feature is desirable and
commands a premium.

Use of Currency Options: Why

1. Speculation
Speculation is a wager on future price direction. A speculator might think the price of a
stock will go up, perhaps based on fundamental analysis or technical analysis. A
speculator might buy the stock or buy a call option on the stock. Speculating with a call
option—instead of buying the stock outright—is attractive to some traders since options
provide leverage. An out-of-the-money call option may only cost a few dollars or even
cents compared to the full price of a $100 stock.
 2. Hedging
Options were really invented for hedging purposes. Hedging with options is meant to
reduce risk at a reasonable cost. Here, we can think of using options like an insurance
policy. Just as you insure your house or car, options can be used to insure your
investments against a downturn.
Imagine that you want to buy technology stocks. But you also want to limit losses.
Byusing put options, you could limit your downside risk and enjoy all the upside in a
cost-effective way. For short sellers, call options can be used to limit losses if the
underlying price moves against their trade—especially during a short squeeze

Exercise: Currency Call Option and Currency Put Option

Currency Call Option Currency Put Option

Contract-one contract for Contract-one contract for three
three months; months;
Volume = 20,000 Pound Volume = 20,000 Pound
Spot Market Price(So) , £ 1= Spot Market Price, £ 1= Tk. 125
Tk. 125 Strike Price £ 1= 126
Strike Price (K) £ 1= 123 Premium on Put, Tk. 0.03 per
Premium on Call Tk. 0.04 pound
per pound
When to K < So K > So
exercise? This is called in the money This is called at the money putl
call option. That is, option. That is, exercising put
exercising call option gives option gives you a positive
you a positive ending value. ending value

Cost of Cc = NOC × Volume × Pp = NOC × Volume × Premium

Currency Premium on call on Put
Option
Situation
Analysis
Ending Ending Value=(So-K)NOC Ending Value==(K -So)NOC
Value ×Volume ×Volume
Profit (Loss) Profit(Loss) on Call Option= Profit (loss) on Put Option =
on Option Ending Value-Cost of Call Ending Value-Cost of Put
When not to K > So K < So
exercise? This is called out of the This is called out of the money
money call option. put option. Because, exercising
Becasuse, exercising call put option gives you a negative
option gives you a negative ending value.
ending value.

Factors Affecting Currency Call option Premium and Currency Put Option Premium

Factors Currency Call Option Currency Put Option

Level of Existing Spot The higher the spot price relative to Reverse
Price relative to strike the strike price, the higher will be
Price the option price. Because, there is a
higher probability of exercising
currency call option substantially at
lower rate than what you could sell
it for.
Length of Time before Price of call option is high if there is Same is the case of Call
Expiration Date a longer period of time before option. A longer period
expiration. Reason being, spot price creates a higher probability
is likely to rise above strike price. for the currency to move
within a range where it would
be feasible to exercise the
option (irrespective of call or
put).
Potential Variability of More volatile currencies will hive As with the currency call
Currncy higher call option price or premium. options, the greater the
variability, the greater will be
the put option premium,
again reflecting a higher
probability that the put option
may be exercised.