Part II: The Foreign Exchange Markets

C7 Foreign Currency Options

Chapter
7
Foreign Currency Options

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Motives for Recent Innovations

Demand Side
With the floating of exchange rates in 1973, a new factor was introduced in
international finance. However, exchange rate volatility – substantially higher
interest rate volatility – witnessed during the eighties led to the demand for
newer kinds of risk management tools which would enable investors and
borrowers to minimise, if not totally eliminate, exchange and interest rate risks.
Supply Side
As the traditional sources of income for banks and investment banks such as
interest, commissions, fees, etc. were subjected to a squeeze, they started
offering complex, innovative deals and products, often tailored to the specific
needs of a borrower or an investor, in the hope of skimming off fat fees before
the competitors wised up to the fact and started offering similar products.

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

What is a Currency Option?

A currency option confers on its buyer the right either to buy or to sell a
specified amount of a currency at a set price known as the strike price.
1. The exercise or strike price, i.e., the exchange rate at which the foreign
currency can be purchased (call) or sold (put);
2. The premium, i.e., the cost price, or value of the option itself;
3. The underlying or actual spot exchange rate in the market.
Advantages
 The option buyer, at the outset, judges the worst case scenario.
 Options provide a flexible hedge offering a range of prices where the
option can be exercised.
 Options provide major possibilities in the range of tools available to
treasures and traders.
 Futures require daily margins to cover credit risk while forwards require a
bank credit line. Copyright © 2003, Madhu Vij

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Trading of Options
FX options are traded in two distinct markets.
1. OTC
2. Exchange

Cont….

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Feature Over The Counter Exchange Listed

Amount Any, subject to a minimum Fixed by contract size or a multiple thereof

Maturity Overnight to five years Fixed day each month for first three months
then quarter months to one year
Strike Any, within reason Only those listed per schedule
Strike quotation As in the FX market, Generally in US cents per currency.
although exchange-type Resulting in the reciprocal of the rate
available Quoted in the FX market
Currency Any pair that has active Only those listed
spot and forward market
Margins None, but credit line required Yes, on sales only
Price quotation Professional (interbank) in US dollars per currency or foreign currency
volatility terms. Other as
requested, usually % per currency for cross-rate contracts
Style American or European American or European (PHLX) European
(IMIM)
Access Trade with a bank Order placed with a broker
Commissions None, if dealt directly with Bank Broker, exchange fees

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Liberalising Options in India

In India, while cross currency options have been used, the volumes have not
been heavy. In a bid to impart flexibility to the execution of cross currency
options, the Reserve Bank of India allowed foreign exchange dealers to buy
options from members of internationally recognised and approved exchanges.
Foreign exchange dealers who are also members of international options
exchanges have the flexibility to go to the exchanges and buy options which
are listed on them.

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Applications of Currency Options

 Exporters seeking to protect and maximise the value of foreign currency
denominated revenues.
 Importers seeking to protect and minimise costs.
 Companies holding rights to purchase foreign currency denominated
goods.
 Corporations that are planning investments, acquisitions or divestiture.
 Issuers who have benefited from having raised funds or leased low
interest rate currency that subsequently weakens beyond a fully hedged
break-even rate and holds prospects of further depreciation.
 Portfolio managers working to enhance total return through active
management of currency component.
 Any firm facing foreign currency denominated obligation or revenue
contingent upon other business factors. Copyright © 2003, Madhu Vij

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Currency Option Fundamentals

Options are derivative securities that are derived from some underlying assets
(stock, index, currency interest rate, commodity) and their prices depend
critically on the spot values of those assets.

Option Instruments

Basically there are two types of option instruments

i. Call Option

ii. Put Option

Cont….

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Option Categories
i. According to the type of leakage exhibited by their underlying assets.
ii. According to the nature of underlying asset.
 Options Based on Type of Leakage
a. Zero Leakage Option Instruments
- Gold Options
- Stock Options
b. Discrete Leakage Option Instruments
- Stock Options
- Stock Index Options
c. Continuous Leakage Option Instruments
- Currency Options
- Future Options
 Option instruments can also be classified as
a. Options on Actuals
b. Options on Futures Copyright © 2003, Madhu Vij

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Mechanism of Option Trading

i. the processes involved in executing option trading;
ii. the infrastructure (clearance facilities and requirements) and regulations.
Executing Option Tradings

Exchange Trading System

(a) Chicago Board Option Exchange (CBOE) Market Maker System
(b) American and Philadelphia Exchange Specialist System

Specialist System vs Market Maker System

i. Make the market in a stock by buying and selling from their own inventory.
ii. Keep the public book of orders consisting of limit orders and stop orders.

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 Part II: The Foreign Exchange Markets
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Relationship between Options and Futures

The most important distinction between an option and a futures or forward is
that there is a symmetrical pay-off with the futures contract whereas there is a
asymmetrical pay-off with an option. The nature of the symmetry refers to the
patterns of pay-offs around the exercise price for an option or the settlement
or contract price for a futures. This difference in symmetries between options
and futures suggests that it may be possible to combine options in such a way
that the pay-off of a futures contract can be duplicated.

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

The Pricing of Currency Options

Stock Price

At expiration, a call option must have a value that is equal to zero or the
difference between the stock price and the exercise price whichever is greater.

Exercise Price

If two call options are alike, except that the exercise price of the first is less
than the exercise price of the second, then the option with the lower exercise
price must have a price that is equal to or greater than the price of the option
with the higher exercise price.

Cont….

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

The Role of Time to Expiration

A mathematical relationship exists between the influence on a currency

option’s price of the interest rate differential and the influence of time to
expiration. The longer the time to expiration, the greater is the influence of the
interest rate differential.

Interest Rates

Assume that a stock now sells for Rs 100 in the market and over the next year
its value can change 10% in either direction. Risk free rate of interest is 12%
and a call option exists on the stock with a value of Rs 100 and an expiration
date one year from now.

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Using Currency Option

In principle, call options give the customer the right to purchase and put
options give the right to sell the contracted currencies at the expiration date.
An option that would be profitable to exercise at the prevailing exchange rate
is said to be ‘in-the money’. Accordingly, an ‘out-of-the money’ option is one
that would be profitable to exercise at the current exchange rate. The price at
which the option is exercised is called the exercise price or strike price. An
option whose spot exchange rate is the same as the exchange price is known
as ‘at-the money’.

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 Part II: The Foreign Exchange Markets
C7 Foreign Currency Options

Speculating with Currency Options

Break-even Point from Speculation
The purchaser of a call option will break even if the revenue from selling the
currency equals the payments for (i) the currency (at the strike price), and (ii)
the option premium. In other words, regardless of the number of units in a
contract, a purchaser will break even if the spot rate at which the currency is
sold is equal to strike price plus the option premium. The computation of the
break-even point is useful for a speculator deciding whether to purchase a
currency call option or not.
Numerical Example
 Put option premium on British pound = $.04 per unit
 Strike price = $1.50
 1 option contract represents 32,000 pound.
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