Ministry of Education and Science of Ukraine
Kremenchutsk National University named after. M. Ostrogradsky
Robot control
from the discipline “International credit, economic and foreign exchange transactions”
on the topic: “Currency options”
currency option buyer exchange
Kremenchuk 2011
Currency options
A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to purchase a specified amount of currency at a predetermined price and within a predetermined period, regardless of the market price of the currency, and imposes an obligation on the writer (writer) to deliver to the buyer currency within a specified period if and when the buyer wishes to carry out an option transaction.
A currency option is a unique trading instrument, equally suitable for trading (speculation) and risk insurance (hedging). Options allow you to adapt the individual strategy of each participant to market conditions, which is vital for a serious investor.
Option prices, compared to the prices of other currency trading instruments, are influenced by a greater number of factors. Unlike spots or forwards, both high and low volatility can create profitability in the options market. For some, options represent a cheaper currency trading tool. For others, options mean greater security and accurate execution of stop-loss orders.
Currency options occupy a rapidly growing sector of the foreign exchange market. Since April 1998, options have accounted for 5% of the total volume. The largest hub for options trading is the US, followed by the UK and Japan.
Option prices are based on and are secondary to RNV prices. Therefore, an option is a secondary instrument. Options are usually referred to in connection with risk hedging strategies. Traders, however, are often confused about both the complexity and ease of using options. There is also a misunderstanding of the power of options.
In the foreign exchange market, options are available in cash or in the form of futures. It follows from this that they are traded either “over-the-counter” (OTC) or on a centralized futures market. The majority of currency options, approximately 81%, are traded OTC (see Figure 3.3.). This market is similar to the spot and swap markets. Corporations can contact banks by telephone, and banks trade with each other either directly or through brokers. With this type of dealing, maximum flexibility is possible: any volume, any currency, any contract deadline, any time of day. The number of currency units can be whole or fractional, and the value of each can be assessed in either US dollars or another currency.
Any currency, not just those available in futures contracts, can be traded as an option. Therefore, traders can operate with the prices of any, even the most exotic, currency they need, including cross-prices. The validity period can be set to any amount - from several hours to several years, although generally the terms are set based on whole numbers - one week, one month, two months, etc. RNV operates continuously, so options can be traded literally around the clock.
Trading options on currency futures gives the buyer the right, but not the obligation, to physically own the currency futures. Unlike currency futures contracts, purchasing currency options does not require an initial cash reserve (margin). The option price (premium), or the price at which the buyer pays the seller (writer), reflects the buyer's overall risk.
The following seven main factors influence option prices:
1. Currency price.
2. Strike (exercise) price.
3. Currency volatility.
4. Validity period.
5. Difference in discount rates.
6. Type of contract (call or put).
7. Option model – American or European.
Foreign exchange premium is a positive difference between the formal and current exchange rates.
Types of currency options: call option, put option
An option can be to buy or sell the underlying asset.
Call option is an option to buy. Gives the option buyer the right to buy the underlying asset at a fixed price.
A put option is an option to sell. Gives the option buyer the right to sell the underlying asset at a fixed price.
Accordingly, four types of options transactions are possible:
Buy Call Option
Write (sell) call option
Buy Put Option
Write (sell) put option
Buying a call option
This strategy is most often used when prices for a particular product are expected to rise.
In this case, the investor's risk is limited only by his premium - part of the price of the product. In a situation where he buys 80 call options, the premium is 5. This means that he is only risking those five. This means that buying an option involves less risk than buying a specific commodity. However, even in this case, the premium is at risk, so there is a possibility of losing the entire investment, even if the amount invested was small.
Less risk means less return. The profit from buying options is quite small. This is due to the fact that according to the contract, transactions can only be performed at a fixed price.
Selling a call option
When selling a call option, the seller takes quite a lot of risk because he must deliver the commodity at a predetermined price, the so-called uncovered strategy.
Given this risk, the maximum profit the seller can receive is the premium. So, when he buys 80 call options, the premium is 5. Selling a call option to open a position is what is called a short call option.
Buying a put option
In this case, as when selling a call option, the risk is limited only by the size of the premium. An option is purchased with the aim of generating income from a fall in prices for a specific asset. The shareholder acquires the right to sell the asset at a fixed price, and he will receive a profit only if the price of the asset falls.
The holder can receive the maximum income from this transaction only if the prices for the goods fall to zero. Buying a put option to open a position is a long put option.
Selling a put option
When selling a put option, the holder takes quite a lot of risk, since he is obliged to deliver a certain product at a fixed price. Moreover, if the market price of an asset falls, the seller is forced to pay a large amount of money for the depreciated item. If the asset price falls to zero, the investor will lose the contract's strike price and premium.
As for the income from the sale of the option, it is made with the expectation that there will be no request for its exercise. Selling a put option to open a position is a short put option.
Option style.
Options differ in style: European option, or European style option (European option, European style) and American option, or American style option (American option, American style).
The main difference between them is that they have different terms of execution. Next, you will see that due to the influence of such factors as the life of the option contract, the costs (premiums) of European and American options are different.
A European option can be exercised within a very limited period of time around the expiration date of the option. Formally, it is considered that this is the day that is determined as the date of execution of option contracts. However, the practice of placing orders and the reconciliation procedure predetermine somewhat wider boundaries, which nevertheless still fit into a certain number of hours that do not expand the horizons too much.
An American option can be exercised at any time before the option expires. For such an option, execution is determined solely by the rules that are in force at the current time regarding the delivery time of the asset underlying it, as well as the capabilities of the broker through which one is exercised. walkie-talkies on the market. There may also be restrictions on the number of option contracts executed during one trading day. Typically this is 2000 option contracts.
Types of currency options by location
Options contracts can be divided into two types: exchange-traded options contracts and over-the-counter options contracts. Most of the world's stock, commodity and financial futures exchanges offer futures contracts, transactions in which are carried out under their control.
Exchange options are standard exchange-traded contracts and are traded similarly to futures contracts. For such options, the exchange establishes contract specifications. When concluding transactions, trading participants only negotiate the amount of the option premium; all other parameters are standard and established by the exchange. The quote for an option published by the exchange is the average premium for a given option per day. From a stock trading perspective, options with different strike prices or expiration dates are considered different contracts. For exchange-traded options, the clearing house keeps records of participants' positions for each option contract. That is, a trading participant can buy one contract and if he sells a similar contract, then his position is closed. The exchange clearing house is the counterparty to each party to the options contract. Exchange-traded options also have a mechanism for charging margin fees (usually paid only by the seller of the option).
Over-the-counter options, unlike exchange-traded ones, are concluded on arbitrary conditions that are agreed upon by the participants when concluding a transaction. The technology of conclusion is similar to forward contracts.
Topic 14. Foreign exchange option and option foreign exchange strategies
Transactionswith Option(lat. optio - choice, desire, discretion) - an agreement under which a potential buyer or potential seller receives the right, but not the obligation, to purchase or sell an asset (commodity, security) at a pre-agreed price at a point in the future specified by the agreement or over a certain period of time. An option is one of the derivative financial instruments.
Option premium is the amount of money paid by the buyer of an option to the seller when entering into an option contract. In economic essence, a premium is a payment for the right to conclude a deal in the future.
Transactions with options are fundamentally different from forward and futures transactions. There are two parties involved in an option transaction: the seller of the option (the option writer) and the buyer (the option holder). The option holder (buyer) has right, and not an obligation to implement the transaction.
Unlike a forward, an option contract is not binding; its holder can choose one of three options :
exercise an option contract;
leave the contract unfulfilled;
sell it to another person before the option expires. The option writer undertakes to buy or
Cost of buying an option (premium ) is determined as a percentage of the amount of the option agreement or as an absolute amount per unit of currency and is paid by the buyer at the time of sale of the option well before the completion of the option agreement, regardless of whether it is even exercised or not.
The option price (premium) is a contractual value and depends on the volume of purchase and sale of currencies, the type of currencies, the current exchange rate and the exercise price of the option. The latter, in turn, as a rule, depends on the current exchange rate and the prospects for its changes, information about which can be provided by data on forward exchange rates published in financial publications.
In any case, the exercise price is calculated in such a way that both the buyer and the seller have some benefit after the option is exercised.
Mechanism for the implementation of options with securities. The procedure for concluding and implementing option contracts on currency and stock exchanges.
Rules and mechanism for calculating and fixing the forward option exchange rate in a contract. Basic calculation methods. Modern option strategies and their modifications. Brief description of various diversified option strategies, their goals and methods of practical implementation.
There are options:
for sale (put option) - Grants the option buyer the right to buy the underlying asset at a fixed price;
for purchase ( call option ) - Grants the option buyer the right to sell the underlying asset at a fixed price;
bilateral ( double option ).
The two most common styles of options are American and European.
American option may be redeemed on any day before the option expires. That is, for such an option a period is specified during which the buyer can exercise this option.
European option can only be redeemed on one specified date (expiration date, execution date, maturity date).
Accordingly, it is possible four types of options transactions:
buy call option;
write (sell) call option;
buy put option;
write (sell) put option.
Option term(expiration period) is the point in time at the end of which the option buyer loses the right to buy (sell) the currency, and the option seller is released from his contractual obligations.
Option basis- this is the price at which the option buyer has the right to buy (sell) the currency if the contract is implemented. The base value is determined at the time the transaction is concluded and remains constant until the expiration date.
The option price depends on a number of factors:
base price (strike price);
current exchange rate (spot);
market variability (volatility);
option term;
average bank interest rate;
the relationship between supply and demand.
The option price includes:
internal (actual) value;
external (temporary) value. Intrinsic value option is determined by the difference between its
A currency option is one of the types of equity securities. This document is especially popular in the foreign exchange market and banking. It is purchased mainly by traders who make money by buying and selling foreign currency.
How is a currency option different from a regular one?
An option is a contract in which one of the parties acquires the right to sell (buy) an underlying asset at a fixed price within a predetermined period of time. A currency document is a document whose underlying asset is a currency unit. Such securities are very common in interbank relations and in specialized markets.
Each contract must stipulate the following points:
1) Type of document. A security can be divided into two types depending on the right it gives after acquisition.
2) Underlying asset. The currency pair that is the main object of the contract must be precisely specified.
3) Strike price (execution price). The seller of the option is obliged to sell (buy) the asset at this price, regardless of how it has changed over time.
4) Deadline. The buyer can exercise his right only within a certain period, usually from several days to several months.
5) Option premium- the amount of money that the buyer pays to the seller at the time of conclusion of the contract. The payment is a kind of compensation for the risk assigned to the seller; quite often it is called the option price.
Main types of currency options
The contract holder can either sell or buy the underlying asset. Depending on this, the contract can be divided into two types.
Call options
A call option (buyer's option) is a contract in which one of the parties receives the right to buy the underlying asset. The sale price is agreed upon in advance and does not change throughout the transaction. The seller is obliged to purchase the asset at the strike price, regardless of how much it differs from the market price, in return for which he asks for a small premium.
A currency option is a great way to make money on exchange rate fluctuations. The trader purchases it in the hope that the value of the base currency will increase in the near future. The purchase of a security differs from ordinary investments in currencies in minimal risks, because even if the underlying asset falls significantly in price, the trader will only lose the money that he gave to the seller as a premium.
An example of using a currency call option
The trader purchases a security to buy euros at the current exchange rate (for example, 50 rubles). He does this in the hope that during the validity of the right given to him, the exchange rate will begin to rise. The bonus is equal to 5% of the amount that can be purchased. If the investor wanted to receive 1000 euros, he must pay 50 to the seller. A currency call is profitable only if the rate increases by more than 5%, otherwise he will give the seller more than he earns on the difference between the strike and the market price.
Let's assume that over the designated period the euro has grown by 10%, which means that the investor will receive a 5% profit on the amount invested, i.e. 10% increase - 5% bonus. If you subtract 5% from the amount of 1000 euros, you get a very small profit of 50 euros. Experienced investors work with more impressive amounts, and even such a small increase can provide excellent income.
Put options
A security that gives the holder the right to sell an asset at a specified price is called a put option.
In the foreign exchange market, a put is mostly needed to insure an investment in a currency that has already been made. For example, if a trader keeps his savings in foreign currency, but soon learns about future inflation. Then he acquires a put and can be calm: the funds he invested will be returned to him minus the minimum expenditure on the contract.
An example of using a currency put option
You can make money not only on the growth of exchange rates, but also on its decline. To do this, you need to sell the currency in the future at the price that is valid at the moment. For this purpose, many investors use currency put options.
Let's assume that foreign exchange market data indicate that the dollar will soon fall. Such information is a good reason to earn extra money, but certain difficulties arise here, because in the usual understanding, currency inflation is a loss of savings. In fact, with the right approach, even negative changes in exchange rates can make money.
The investor purchases an issue paper for the sale of a certain number of dollars at the current price and pays 5% of the amount he wants to sell for this right. At the time of the contract, the dollar falls by 20%. The trader purchases 20 thousand dollars at the current price and sells them to the person selling the securities at the strike price. Taking into account the premium, which invariably remains with the seller, the trader earns 15% profit from his transaction, i.e. 3 thousand dollars.
“Geographical” types of currency options
Securities of this kind first appeared in Europe, but found great popularity in America. Gradually, the procedure for exercising the right certified by an option began to change depending on the geopolitical attachment: American options operate according to their own principle, European ones - according to their own. In Asia, the American type of security has found another direction.
American option
At the moment, the American model is more popular and widespread. It is used everywhere and, oddly enough, even in Europe.
Its main difference from the European model is that the buyer has access to early expiration - the exercise of data rights in the option.
Early execution of the contract is beneficial for its holder. At the time of its action, the price of the asset may greatly increase or, on the contrary, decrease. The trader has the right to convert currency at the moment when it is profitable for him.
European option
Premiums for such a document are slightly below average. The fact is that the seller is exposed to minimal risk, since the buyer cannot take advantage of early expiration. A certain period must pass from the conclusion of the contract to its execution. Only after this time has expired can the buyer exercise his right. He will not be able to profit from an intermediate increase (decrease) in the price of the asset.
Asian option
An option is in some way a commodity and must have its own price. Since the advent of global options exchanges, many analysts have asked themselves the question: how to correctly calculate the premium.
The fairest calculation model is the one that focuses on the average price of an asset for a certain period. It was first tried by a branch of an American bank in Tokyo. Soon, contracts for which premiums were calculated in this way were called Asian.
Exotic types of currency options
Gradually, the concept of what a currency option is began to change and take on a completely different form. There are types of documents that are only distantly related to ordinary securities.
Barrier currency options
Options are a game of chance. Each of the parties to the agreement strives to obtain maximum profit, and is ready to lose everything if the outcome is unsuccessful.
Barrier currency options were the first step towards turning an ordinary security into a global digital market, where the main idea of every participant is to get as much money as possible.
Barrier agreements differ from ordinary ones by the presence of an obstacle to the exercise of the right to purchase or sell an asset: in order for the document to be converted, the price of the underlying asset must reach a certain level.
Since the buyer’s risk increases, the contract indicates a more favorable price for him, which may differ significantly from the market price. For example, the seller undertakes to sell dollars at a price of 35 rubles (at the moment they cost 40) if within 1 month their price reaches 45 rubles.
With the beginning of the popularity of barrier transactions, the underlying asset began to gradually go out of circulation. Instead of buying and selling currency, the seller of the security simply compensated for the profit that the buyer could receive from his further transactions. This approach is beneficial for both parties: the seller spends less of his time, and the buyer is insured against additional risks, for example, from the fact that in the period from converting the document to resale of the asset, the exchange rate may change in an unfavorable direction.
Ranged currency options
In the case of them, the buyer can exercise his right only if the exchange rate at the time of execution of the contract is in a certain range, more (less than) the number n, but not more (less than) the number n+m.
For example, a document to purchase a dollar at a price of 35 rubles can be sold only if, at the end of the execution period, the rate is in the range of 36-40 rubles. The price range is proposed by the seller; the buyer has the right to demand its change.
The range can be at the level of the current exchange rate, more or even less. Essentially, an investor is betting that the value of an asset will increase or decrease.
The latest step in the transformation of ordinary securities is binary options. They differ from their ancestors very much and it is possible to trace any similarities between them only by learning what barrier and range agreements are.
In binary options, the asset has completely disappeared from circulation. The main object was its price. Traders place bets on its behavior over a certain period of time. If they think it will rise, they bet on a “call”; if they believe it will fall, they bet on a “put”. As you can see. Even the concepts of call and put have lost their former meaning.
The execution price does not depend on the behavior of the asset on the foreign exchange market: it is set by the broker (option seller). The execution price is indicated as a percentage of the bet amount. The option premium depends on the buyer: the more he puts, the more he gets and the more he can lose. The premium remains with the broker only if the investor’s bet does not work. It turns out that no matter the outcome, only one party to the agreement is left with money in hand, which is why such transactions are often called “all or nothing”.
Currency options in banking legal relations
At the moment, the most accessible option sellers are second-tier banks. They distribute securities to both individuals and legal entities.
Ordinary citizens can purchase this security as a guarantor for the reimbursement of a deposit in foreign currency. Options for individuals are a new direction in banking investment, so it is worth talking about it in more detail.
A currency option with deposit coverage is an opportunity to obtain a more favorable interest rate on a deposit and at the same time a rather serious financial risk. Essentially, this is a put option: the client opens a deposit in the base currency and acquires the right to sell this currency to the bank. The document stipulates the rate that the client chooses, as well as the amount of the bank’s premium. The range of possible rates is chosen by the bank. The contract has a period of one week to a month. If, after this period, the rate chosen by the client is more favorable than the current one, he can use his emission document and convert the savings into foreign currency at a more favorable rate. In addition, the bank returns the premium amount.
If the selected rate is lower than the current one, the client leaves his right unclaimed, and the premium remains with the bank.
That is, for example, a client opens a deposit in the amount of 100 thousand rubles and purchases an option from the bank to convert this amount into dollars at the rate of 38 rubles. At the moment the rate is 40 rubles. The deadline is one week. For the contract, the client must pay 10% of the deposit, but only if he does not use it.
If, at the end of the contract, the dollar exchange rate remains unchanged or even increases, the client remains in the black. He exercises his right and transfers the deposit into dollars at a rate below the market one. The bank reimburses the cost of the security as a bonus. If the dollar exchange rate fell below 38 rubles, it would be unprofitable for the client to use the option. He simply lets it burn and at the same time loses 10 thousand rubles (option premium).
No matter how welcoming everything may sound, such a banking offer is not very profitable. The bank puts forward clear conditions that do not allow the client to make a big profit. Interest on deposits is usually lower than market averages and favorable changes in exchange rates only cover this difference.
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A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to purchase a specified amount of currency at a predetermined price and within a predetermined period, regardless of the market price of the currency, and imposes an obligation on the writer (writer) to deliver to the buyer currency within a specified period if and when the buyer wishes to carry out an option transaction.
A currency option is a unique trading instrument, equally suitable for trading (speculation) and for risk insurance (hedging). Options allow you to adapt the individual strategy of each participant to market conditions, which is vital for a serious investor.
Option prices, compared to the prices of other currency trading instruments, are influenced by a greater number of factors. Unlike spots or forwards, both high and low volatility can create profitability in the options market. For some, options represent a cheaper currency trading tool. For others, options mean greater security and accurate execution of stop-loss orders.
Currency options occupy a rapidly growing sector of the foreign exchange market. Since April 1998, options have accounted for 5% of the total volume (see Fig. 3.1.). The largest hub for options trading is the US, followed by the UK and Japan.
Option prices are based on and are secondary to RNV prices. Therefore, an option is a secondary instrument. Options are usually referred to in connection with risk hedging strategies. Traders, however, are often confused about both the complexity and ease of using options. There is also a misunderstanding of the power of options.
In the foreign exchange market, options are available in cash or in the form of futures. It follows from this that they are traded either “over-the-counter” (OTC) or on a centralized futures market. The majority of currency options, approximately 81%, are traded OTC (see Figure 3.3.). This market is similar to the spot and swap markets. Corporations can contact banks by telephone, and banks trade with each other either directly or through brokers. With this type of dealing, maximum flexibility is possible: any volume, any currency, any contract deadline, any time of day. The number of units of currency can be whole or fractional, and the value of each can be assessed in either US dollars or another currency.
Any currency, not just those available in futures contracts, can be traded as an option. Therefore, traders can operate with the prices of any, even the most exotic, currency they need, including cross-prices. The validity period can be set to any amount - from several hours to several years, although generally the terms are set based on whole numbers - one week, one month, two months, etc. RNV operates continuously, so options can be traded literally around the clock.
Trading options on currency futures gives the buyer the right, but not the obligation, to physically own the currency futures. Unlike currency futures contracts, purchasing currency options does not require an initial cash reserve (margin). The option price (premium), or the price at which the buyer pays the seller (writer), reflects the buyer's overall risk.
The following seven main factors influence option prices:
1. Currency price.
2. Strike (exercise) price.
3. Currency volatility.
4. Validity period.
5. Difference in discount rates.
6. Type of contract (call or put).
7. Option model – American or European.
The price of a currency is the main pricing component and all other factors are compared and analyzed taking into account this price. It is changes in the price of a currency that determine the need to use an option and affect its profitability. The effect of currency price on an option premium is measured by the "Delta" index, named after the first Greek letter used to describe aspects of pricing when discussing factors affecting the value of an option.
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Delta
Delta, or simply A, is the first derivative of the option pricing model (OPM). This index can be viewed in three aspects:
1. As a change in the price of a currency option (CVO) relative to a change in the price of a currency. For example, the change in the price of an option with A=0.5 is expected to be half the change in the price of the currency. Therefore, if the price of a currency rises by 10%, the price of an option on that currency will presumably rise by 5%.
2. As the degree of risk insurance (hedge ratio) with an option relative to a currency futures, necessary to establish a balanced risk (neutral hedge). For example, with A=0.5, you will need two option contracts for each futures contract.
3. As a theoretical or equivalent equity position. With this approach, “Delta” represents a part of a currency futures contract in which the call buyer is in the “buy” position (long) or the put buyer is in the “sell” position (short). If we use the same indicator A=0.5, this will mean that the buyer of the put option is selling 1/2 of the currency futures contract.
Traders may be unable to guarantee prices in spot, irreversible forward or futures markets, leaving the Delta position temporarily unhedged. To avoid the high cost of insurance and the risk of unusually high volatility, a trader can hedge the position of the original option with other options. Such methods of risk neutralization are called “Gamma” or “Vega” insurance.
Gamma
Gamma (G) is also known as the “curvature of the option”. This is the second derivative of the option pricing model (OPM) and represents the degree of change in the option's Delta, or Delta sensitivity. For example, an option with A=0.5 and G=0.05 would presumably have A=0.55 if the price of the currency rises 1 point, or A=0.45 if the price falls 1 point. "Gamma" varies from 0 to 100%. The higher the Gamma, the higher the sensitivity of Delta. Therefore, it may be useful to interpret Gamma as an indicator of the acceleration of the option relative to the movement of the currency.
Vega
“Vega” characterizes the impact of volatility on the value of the premium for an option. “Vega” (Ξ) characterizes the sensitivity of the theoretical option price relative to changes in volatility. For example, Ξ=0.2 creates a 2% increase in premium for each percentage increase in estimated volatility and a 2% decrease in premium for each percentage decrease in estimated volatility.
An option is sold for a specified period of time, after which there is a date known as the expiration date. A buyer wishing to exercise an option must notify the writer on or before the expiration date. Otherwise, it releases the writer from any legal obligations. The option cannot be exercised after expiration.
Theta
Theta (T), an index also known as time decay, is used when the theoretical value of an option is lost due to very slow or no currency movement.
For example, T=0.2 means a loss of 0.02 premium for each day when the currency price does not change. The internal price does not depend on time, but the external price does. Time decay increases as expiration approaches because the number of possible exits continually decreases over time. The influence of the time factor is maximum on the at-the-money option and minimum on the in-the-money option. The degree of influence of this factor on the out-of-the-money option is somewhere within this interval.
Bid-offer spreads in the foreign exchange market can make writing options and trading irreversible forwards too expensive. If an option ends up deep in the money, the difference in discount rates achieved by quick exercise may exceed the value of the option. If the option volume is small or close to expiration and the value of the option consists only of its intrinsic value, early exercise may be preferable.
Due to the complexity of the determining factors, calculating the price of options is difficult. At the same time, without a pricing model, options trading is nothing more than an ineffective game of chance. One idea for pricing an option is to consider buying one's own currency with a foreign currency at some price X as the equivalent of an option to sell the foreign currency for one's own currency at the same price X. Thus, a call option in one's own currency becomes a put option at foreign and vice versa.
In the previous chapter, we studied the three main types of contracts that are used in currency exchanges: spot, forward and futures. This chapter examines the nature and use of foreign exchange options contracts.
Options should be thought of as more complex forms of contracts that govern foreign exchange. We'll start with the characteristics of options trades, taking into account their variety and usage. We conclude this chapter with a discussion of the principles underlying option pricing.
After studying the material in this chapter, you:
Understand the essence of an option contract;
You will be able to understand the types of options contracts;
Get acquainted with the operations carried out in the foreign exchange options markets;
Understand the general economic principles that underlie the use of put and call options, which respectively provide the right to sell or buy such contracts for a fixed price;
Understand the costs and risks associated with using currency options;
Understand the economic factors that determine option premiums.
CURRENCY OPTIONS
Forward and futures contracts obligate the investor to exchange a specified amount of one currency for another at a specified time in the future. The investor must make such an exchange, even if the transaction has become unprofitable for him. But many investors prefer a situation where making a currency exchange is not an obligation for them, but a right: if the planned transaction turns out to be profitable, carry out this exchange; if the deal is not profitable, refuse the currency exchange.
A contract that provides such attractive terms is called an option. Under contracts of this type, the investor has the right (and not the obligation) to make a currency exchange. The disadvantage of an options contract is that the investor must pay a high premium to induce the other party to sign the contract.
Terminology used in options
An option to buy 31,250 British pounds in 3 months at a price of $1.90 per pound gives the option holder the right to buy 31,250 British pounds from the seller of the option. This right is subject to a payment condition of $1.90 for each pound purchased. Therefore, the owner of the option cannot exercise his right to the pounds without paying them at a price of $1.90 per pound, which is called the exercise price of the option. The time when the limiting condition expires (3 months in this case) is called the option's maturity.
The intrinsic value of an option is the difference between what one would have to pay for the currency (the market exchange rate) without the option and what one would pay if the option were exercised (the strike price). For example, suppose 1 British pound currently sells for $2.00. The intrinsic value of the option is $0.10 per pound (2.00 - 1.90). Since an option does not have to be exercised, its intrinsic value cannot be negative. If the market price of the British pound falls below $1.90, the intrinsic value of the option will become zero.
An option premium is the difference between the market price of an option and its intrinsic value. For example, if an option sells for $0.15 per pound, the premium is $0.05 per pound (0.15 - 0.10).
TYPES OF CURRENCY OPTIONS
Any two parties can enter into a currency options contract, which will determine, by agreement, the amount of currency, the maturity date and the exercise price. Some banks are ready to prepare custom option contracts for their best corporate clients. However, each party is obliged to adhere to the terms of this contract until its expiration, unless a mutually satisfactory replacement for this type of currency exchange is found.
When the number of applications becomes large enough, it becomes possible to organize a secondary market for trading options contracts, similar to the one where transactions with futures contracts take place. In the United States, the Chicago Mercantile Exchange (CHM) conducts organized sales of stock options, and the Philadelphia Securities Exchange conducts organized sales of foreign exchange options.
Similar options on currency futures contracts are sold on the International Foreign Exchange Market. Although this type of option refers to a currency future rather than a currency, it makes no practical difference to options traders.
There is currently an organized market in London for foreign exchange options, known as European options, which can only be exercised on a set date. This distinguishes them from American options, which can be exercised ahead of schedule. There is little difference in determining the value of European and American currency options, although European and American equity options determine their values differently.
Options traded on an exchange require a standardized contract form and performance guarantee, just like futures contracts. Currency options expire on the Fridays preceding the third Wednesday of the month. The amount of currency each option deals with is equal to half of that specified for futures contracts. The Option Clearing Corporation acts as a guarantor for the execution of currency options.
Bringing currency futures options into compliance with the characteristics of futures contracts and guaranteeing their fulfillment is carried out by the International Foreign Exchange Market.
PUT OR CALL OPTIONS
There are two main types of options contracts. Call options give the owner the right to buy a specified amount of foreign currency at a specified price on a specified date in the future. Puma options give their holders the right to sell, on a specified date in the future, a specified amount of foreign currency at a specified price.
If you exercise your right under a call option, you pay the exercise price, and under a put option, you receive the exercise price. The other party to the option, who is obligated to fulfill the conditions requested by the option owner, is called the writer of the option. She participates in the option for a premium to it, which is paid by its future owner.
Consider the actions of an investor who believes that the value of the British pound will increase over the next 6 months from the current $1.95 to $2.10. But he also knows that there is a possibility that the value of the pound could fall unexpectedly. Since the investor has limited financial resources, he does not want to risk buying a pound futures contract. He calls his broker and inquires about call options on British pounds expiring in June. (If this investor believed that the value of the pound would fall, he would be interested in put options). The broker informs him that a call option with a strike price of $2.00 is currently trading at a premium of $0.0350. Since both the strike price and the premium are in dollars, the investor instructs the broker to buy one call option and pays (31250) (0.0350) - $1093.75 (the numbers from the previous example are used here) plus a $25 commission.
If the spot price of the pound increases as the option expires, the option increases in value. If the specified price decreases, then the value of the option falls. However, in this case, additional investments will never be required, unlike futures transactions. The investor will not lose more than he initially spent on
this option. The only people exposed to the risk of uncertain loss here are the option sellers, and only they must enforce the margin requirement.
Although currency options can be held until expiration and then exercised, holders typically sell them early. Let's say the value of the British pound increased to $2.10 in April. The investor cannot, however, exercise his right until the option expires. The intrinsic value of an option, as defined above, is equal to the difference between the market value of the pound and the strike price, i.e. (2.10 ~ 2.00) = $0.10 per pound or (0.10)(31250) = $3125. However, options typically sell for slightly more than their intrinsic value, so our investor can simply sell his option before expiration.
FACTORS DETERMINING OPTION PRICES
Figure 4-1 shows graphs that plot the price and intrinsic value of a foreign exchange call option as a function of the expected spot exchange rate on the option exercise date. Both the intrinsic value of an option and its price are expressed in dollars per unit of foreign currency. The actual value and the price to be paid for the option are determined by multiplying the value of a unit of currency by the number of units stipulated in the option contract. The intrinsic value of an option is equal to the difference between the current spot rate and the strike price, but can never be negative since the investor is not obligated to exercise this type of foreign exchange contract. That is why the continuous line in the figure, showing the change in the intrinsic value of the option, does not depart from the x-axis and only fixes the zero value of the option on it. This happens until the spot rate exceeds the option strike price (X). Every penny increase in the spot exchange rate of the British pound increases the intrinsic value of the option by 1 penny. Therefore, the line showing the intrinsic value of the option rises from point (X), corresponding one to one with the rise in the spot rate exceeding the strike price.
The dotted line represents the market price of the option. At all values of the spot rate, the option price exceeds its intrinsic value. The difference between the price investors are willing to pay for an option and its intrinsic value is the option premium.
Investors are willing to pay these premiums because there is a possibility of large profits if exchange rates rise, while potential losses are limited even if the exchange rate depreciates. When the exchange rate equals the strike price, the option premium is highest.
When the spot rate is below the option strike price and the probability that it will exceed it is small, the premium is reduced. When the spot rate is above the strike price, the premium still decreases because the price of the option, which equals the amount of money the owner is putting into it and stands to lose, goes up.
The option premium is also affected by its expiration date and the volatility of the value of the foreign currency it deals with. Because a longer waiting period increases the likelihood that the exchange rate will exceed the strike price, investors pay more for an option with a longer expiration date. Likewise, a currency that changes its value more dynamically has a greater chance of its exchange rate being higher than the strike price.
Figure 4-2 shows the intrinsic value and market price of a put option as a function of the expected future spot price. Put options only have value when
The spot rate falls below the strike price. Intrinsic value equals the strike price minus the exchange rate. Since the owner of the option, in cases where spot rates exceed the exercise price, simply decides not to exercise his right, the intrinsic value of the option is considered not negative, but zero.
As with call options, the market price of a put option usually exceeds its intrinsic value. Investors are willing to pay a premium for put options for the same reasons as for call options. Their possible profits from changes in exchange rates before the option expires exceed their possible losses, which are limited by the initial costs. The premium is maximum when the exchange rate equals the strike price. It is an increasing function, depending both on the expiration date of the option and on the instability of the currency with which the option operates.
WHO BENEFITS FROM FOREIGN CURRENCY OPTIONS?
Currency speculators like options because they offer unlimited potential gains while tightly limiting losses. However, if owning options is such a profitable business, why are there those who are willing to sell them? The answer to this question is that the premium that the option seller receives is commensurate with the risk of possible unlimited losses.
Why should you still engage in options contracts? Investors can profit if they have information about future changes in exchange rates that no one else has. Otherwise, other participants in foreign exchange transactions would want to make a profit that significantly exceeds the option premium.
Although some companies might benefit from such information, they use options primarily for other purposes. Consider a US company that knows that it will receive GBP 31,250 in 3 months. It is known that if the value of the pound falls below $1.90, this company has a chance of becoming insolvent. The losses caused by the insolvency far exceed the costs associated with the option of GBP 31,250. This is why the company will pay a significant premium, but avoid the possibility of becoming insolvent.
Currency futures contracts are standardized and backed forward contracts traded on the International Foreign Exchange Market. Currency options are similar to futures contracts, with the only difference being that the owner of the option can choose whether to exercise the contract or not. Currency options can provide either the right to sell a currency or the right to buy it. In order to induce someone to issue an option, the future owner must pay a premium for it. It depends on variables such as the difference between the option exercise price and the value of the currency, the instability of the value of the optioned currency, and the expiration date of the option. To use or not to use a currency option? The choice depends on the relationship between the premium and the potentially unlimited profits that the option can generate.
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