FX Derivatives

Forwards, Futures & Options

Phan Vũ Ngọc Lan

Currency Options

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 What is an FX Option

• A foreign currency option is a contract giving the purchaser

of the option the right to buy or sell a given amount of
currency at a fixed price per unit for a specified time period.
• Feature:
– Underlying asset
– Contract size
– Down payment – premium
– Strike price –exercise
– Expiration day.

– The most important part of clause is the “right, but not

the obligation” to take an action
– Two basic types of options, calls and puts
• Call – buyer has right to purchase currency
• Put – buyer has right to sell currency
– The buyer of the option is the holder and the seller of
the option is termed the writer

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 Calls and Puts

CALL BUYER CALL WRITER

Right to buy Obligation to sell
Expects FC ↑ Expects FC ↓

PUT BUYER PUT WRITER

Right to sell Obligation to buy
Expects FC ↓ Expects FC ↑

Basic Terminology
• Every option has three different price elements
– The strike or exercise price is the exchange rate at which
the foreign currency can be purchased or sold
– The premium, the cost, price or value of the option itself
paid at time option is purchased
– The underlying or actual spot rate in the market
• There are two types of options
– American options may be exercised at any time during
the life of the option
– European options may not be exercised until the
specified maturity date

3
 Plain Vanilla Options as Hedging Tools

• Call Option:
– Used to limit (cap) the local currency cost of a FC payable
(liability)
– Cap is set: Call Strike+Premium
• Put Option
– Used to protect (set a floor) the local currency value of FC receivable
(asset)
– Floor: Put Strike-Premium

Simple Example

• ABC has Euro 10m payment due in 128 days.

• Buys Call options to limit its cost of Euro payment!
• Strike Price: $1.31 per Euro
• Premium: $0.016 per Euro

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 • If spot is >1.31, call option will be exercised!
– Cost=Strike x Underlying Amt + Premium
– Cost= 1.31 x (10,000,000)+0.016*(10,000,000)
– =$13,260,000
– Or unit cost 1.31+0.016=1.3260

Spot<1.31

• If Spot < 1.31, call will not be exercised. We will buy Euro
10m at spot:
• Cost=Spot Rate x 10,000,000+Premium
• =or per unit =Spot Rate+0.016

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 Cost of 10m Euro payment: Range:$1.28-$1.35

Net Cost of Euros vs Spot Cost

13,500,000
13,400,000
Premium=$160,000 Cap =$13,260,000
13,300,000
Per Unit:
13,200,000 1.31+0.016
13,100,000 =$1.3260
13,000,000
12,900,000
12,800,000
1.2800 1.2925 1.3050 1.3175 1.3300 1.3425

Net Cost Spot Cost

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Option Payoff

Option Payoff

300,000
250,000
200,000 Exercise
Do not Exercise (Premium
150,000 Recovery)
100,000 (Premium Lost)
50,000
-
(50,000) Exercise
(100,000)
(Profit)
(150,000)
(200,000)
1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0
00
0

5
28

28

29

29

30

30

31

31

32

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1.

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6
 Net Cost of Euros vs Option Payoff
235,000 13,300,000

13,250,000
185,000 Right Scale
13,200,000
135,000
13,150,000
85,000 13,100,000

35,000 13,050,000

13,000,000
(15,000)
1. 00
1. 25
1. 50
1. 75
1. 00
1. 5
1. 50
1. 5
1. 0
1. 25
1. 0
1. 5
1. 00
1. 5
1. 50
1. 75
1. 00
1. 25
1. 50
1. 75
1. 00
1. 25
1. 50
1. 5
1. 00
1. 5
1. 0
1. 75
00
2

7
0

5
7

2
5
12,950,000
28
28
28
28
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29
29
29
30
30
30
30
31
31
31
31
32
32
32
32
33
33
33
33
34
34
34
34
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1.

(65,000)
12,900,000
(115,000) 12,850,000

(165,000) 12,800,000

Option Payoff Net Cost

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Simple Example

• ABC has Euro 10m receivable (asset) due in 128 days.

• Buys Put options to protect $ value of its Euro receivables
(assets)!
• Strike Price: $1.31 per Euro
• Premium: $0.0385 per Euro

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7
 Effective Receipt of Euros

• Exercise the option if Spot<1.31

• Get : (Strike-Premium)per Euro sold
• =1.31-0.0386=1.2714
• Do not exercises if spot >1.31
• Get: (Spot-0.0386)

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Net Receipt of $

13,200,000
13,100,000 Spot Line
13,000,000
12,900,000
12,800,000 Exercise
Don’t Exercise
12,700,000
12,600,000 Floor
12,500,000
1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0

1. 0
00
0

0
25

26

27

28

29

30

31

32

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1.

Net Receipt Spot Receipts

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8
 Option Payoff

300,000 Exercise
200,000 (Profit)
Exercise
100,000 Premium Decay
-
(100,000)
Don’t Exercise
(200,000) (Premium Lost)
(300,000)
(400,000)
(500,000)
1. 75

1. 0
1. 00

1. 0
1. 25

1. 75
1. 50
1. 25
1. 0

1. 50
1. 75

1. 25
1. 00
75
0
5

0
25

28
25

26

31

32
27

28
29
30

31

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1.

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Foreign Currency Speculation

• Speculation is an attempt to profit by trading on expectations about

prices in the future.
• Speculators primarily use futures and options markets because of
substantial leverage
• A small margin in futures contracts and premium in the options market
allow speculators command large amounts in contracts.
• In both cases speculators make bets in the direction of exchange rates,
however risk-return profile in futures and options are profoundly
different.
• Option contracts allow limited risk directional bets while downside risks
are unlimited in futures contracts.

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9
 Swiss Franc Option Quotations (U.S. cents/SF)

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Option Market Speculation

• Buyer of a call:
– Assume purchase of August call option on Swiss francs with strike
price of 58½ ($0.5850/SF), and a premium of $0.005/SF
– At all spot rates below the strike price of 58.5, the purchaser of the
option would choose not to exercise because it would be cheaper to
purchase SF on the spot market
– At all spot rates above the strike price, the option purchaser would
exercise the option, purchase SF at the strike price and sell them into
the market netting a profit (less the option premium)

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10
 Buying a Call Option on Swiss Francs

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Option Market Speculation

• Writer of a call:
– What the holder, or buyer of an option loses, the writer gains
– The maximum profit that the writer of the call option can make is
limited to the premium
– If the writer wrote the option naked, that is without owning the
currency, the writer would now have to buy the currency at the spot
and take the loss delivering at the strike price
– The amount of such a loss is unlimited and increases as the
underlying currency rises
– Even if the writer already owns the currency, the writer will
experience an opportunity loss

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 Selling a Call Option on Swiss Francs

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Option Market Speculation

• Buyer of a Put:
– The basic terms of this example are similar to those just illustrated with the
call
– The buyer of a put option, however, wants to be able to sell the underlying
currency at the exercise price when the market price of that currency drops
(not rises as in the case of the call option)
– If the spot price drops to $0.575/SF, the buyer of the put will deliver francs
to the writer and receive $0.585/SF
– At any exchange rate above the strike price of 58.5, the buyer of the put
would not exercise the option, and would lose only the $0.05/SF premium
– The buyer of a put (like the buyer of the call) can never lose more than the
premium paid up front

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12
 Buying a Put Option on Swiss Francs

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Option Market Speculation

• Seller (writer) of a put:

– In this case, if the spot price of francs drops below 58.5
cents per franc, the option will be exercised
– Below a price of 58.5 cents per franc, the writer will lose
more than the premium received fro writing the option
(falling below break-even)
– If the spot price is above $0.585/SF, the option will not
be exercised and the option writer will pocket the entire
premium

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13
 Selling a Put Option on Swiss Francs

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Option Pricing and Valuation

• The total value (premium) of an option is equal to the intrinsic value plus time
value.
• Intrinsic value is the financial gain if the option is exercised immediately.
– For a call option, intrinsic value is zero when the strike price is above the
market price
– When the spot price rises above the strike price, the intrinsic value becomes
positive
– Put options behave in the opposite manner
– On the date of maturity, an option will have a value equal to its intrinsic
value (zero time remaining means zero time value)
• The time value of an option exists because the price of the underlying currency,
the spot rate, can potentially move further and further into the money between
the present time and the option’s expiration date.

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14
 Option Pricing and Valuation
• The pricing of any currency option combines six elements:
– Spot rate
– Strike Price
– Time to maturity
– Domestic interest rate
– Foreign currency interest rate
– Volatility (standard deviation of daily spot price movements)

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Option Prices/Value

Factors Call Premium Put Premium

Spot Price + -
Strike Price - +
Time to Expiration + +
Volatility + +
Domestic Interest + -
Rate
Foreign Interest - +
Rate

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 Option Prices

 RfT  RdT
C  S 0e N (d 1)  K e N (d 2)
2
S0  
} {R d  R f  }T
ln {
d1  K 2
 T
d 2  d1  T

Option Price=F(Spot, Strike, Time To Expiration, Volatility, Interest Rate Diff)

How to Use Option Pricing Software- A Short Tutorial

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The Black-Scholes Formula

Stock position Bond Position
The second
term, is the
discounted
c  S0 erfTN(d1)  K erdT N(d2 ) expected cost
of owning the
option. N(d2)
is the risk
delta borrowing neutral
probability
First Term P(St>K ).
Second Term

The first term is the discounted partial expectation of the Stock price conditional
on spot exceeding the Strike price at time t or E(St | St>K)=S0erft erdt N(d1). Note that
the first term does not have the term erdt, because in risk neutral world we assume
expected return on stock is risk free rate rd, and we discount the payoff at the risk
free rate rd, the term cancels out.

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 Foreign Exchange Implied Volatility for Foreign Currency Options, January 30, 2008

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Currency Option Pricing Sensitivity

• Forward rate sensitivity:

– Standard foreign currency options are priced around the forward rate
because the current spot rate and both the domestic and foreign
interest rates are included in the option premium calculation
– The option-pricing formula calculates a subjective probability
distribution centered on the forward rate
– This approach does not mean that the market expects the forward rate
to be equal to the future spot rate, it is simply a result of the
arbitrage-pricing structure of options

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17
 Currency Option Pricing Sensitivity

• Spot rate sensitivity (delta):

– The sensitivity of the option premium to a small change in the spot
exchange rate is called the delta

– The higher the delta, the greater the probability of the option expiring
in-the-money

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Currency Option Pricing Sensitivity

• Time to maturity – value and deterioration (theta):

– Option values increase with the length of time to maturity

– A trader will normally find longer-maturity option better values,

giving the trader the ability to alter an option position without
suffering significant time value deterioration

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18
 Theta: Option Premium Time Value Deterioration

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Currency Option Pricing Sensitivity

• Sensitivity to volatility (lambda):

– Option volatility is defined as the standard deviation of daily
percentage changes in the underlying exchange rate
– Volatility is important to option value because of an exchange rate’s
perceived likelihood to move either into or out of the range in which
the option will be exercised

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19
 Volatility-The Most Important Input
• Note that the only variable that is not observable in the option pricing formula is
the volatility. Its estimation is critical to option pricing!
• Volatility is viewed in three ways:
– Historic
– Forward-looking
– Implied
• Because volatilities are the only judgmental component that the option writer
contributes, they play a critical role in the pricing of options.
• All currency pairs have historical series that contribute to the formation of the
expectations of option writers.
• In the end, the truly talented option writers are those with the intuition and
insight to price the future effectively.

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Currency Option Pricing Sensitivity

• Sensitivity to changing interest rate differentials (rho and phi):
– Currency option prices and values are focused on the forward rate
– The forward rate is in turn based on the theory of Interest Rate Parity
– Interest rate changes in either currency will alter the forward rate, which in
turn will alter the option’s premium or value
• A trader who is purchasing a call option on foreign currency should do so
before the domestic interest rate rises. This timing will allow the trader to
purchase the option before its price increases.

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20
 Currency Option Pricing Sensitivity

• The expected change in the option premium from a small

change in the domestic interest rate (home currency) is the
term rho.
• The expected change in the option premium from a small
change in the foreign interest rate (foreign currency) is
termed phi.

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Interest Differentials and Call Option Premiums

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 Currency Option Pricing Sensitivity

• The sixth and final element that is important to option

valuation is the selection of the actual strike price.
• A firm must make a choice as per the strike price it wishes to
use in constructing an option (OTC market).
• Consideration must be given to the tradeoff between strike
prices and premiums.

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Exhibit 8.14 Option Premiums for Alternative Strike Rates

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 Summary of Option Premium Components

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