Lecture 10.

Futures and Options

on Foreign Exchange (2)
Currency Options Markets
• Prior to 1982, all currency options contracts were OTC options written
by international banks, investment banks, and brokerage houses
• OTC options are tailor-made and generally for large amounts (that is, at least
$1M of currency serving as underlying assets).
• OTC options are typically European style, and they are often written for U.S.
dollars, with the euro, British pound, Japanese yen, Canadian dollar, and Swiss
franc serving as the underlying currency.
• In December 1982, the Philadelphia Stock Exchange (PHLX) began
trading options on foreign currency. In 2008, the PHLX was acquired
by the NASDAQ OMX Group.
• The volume of OTC currency options trading is much larger than that
of organized-exchange option trading.
Currency Futures Options
• A currency future option is an option on a currency futures contract.
• CME Group trades European style options on several of the currency
futures contracts it offers
• With these, the underlying asset is a futures contract on the foreign currency
instead of the physical currency.
• One futures contract underlies one options contract.
• Options on currency futures behave very similarly to options on the
physical currency since the futures price converges to the spot price
as the futures contract nears maturity.
Basic Option-Pricing Relationships at
Expiration
• At expiration, a European option and an American option (which has not been
previously exercised), both with the same exercise price, will have the same
terminal value.
• For call options, the time T expiration value per unit of foreign currency is
stated as the following:
!!" = !#" = Max &" − (, 0
• !!" : American call option value at time T; !#" : European call option value at time T.
• "" : Spot price (exchange rate) at time T; ! : Exercise price per unit of foreign currency.
• Similarly, for put options, the expiration value can be stated as:
+!" = +#" = Max ( − &" , 0
Basic Option-Pricing Relationships at
Expiration
• Call (put) option with !! > # (# > !! ) will be exercised in-the-money.
• It will be exercised because the buyer will make money.
• If !! = #, the option expires at-the-money.
• It will not be exercised because no money will be made by doing so.
• If !! < # (# < !! ), the call (put) option expires out-of-the-money.
• It will not be exercised because the buyer would lose money by doing so and is
under no obligation to exercise the option.
Basic Call Option Profit Profiles
• If the call is in-the-money, it
is worth !! − #.
• If the call is out-of-the-
money, it is worthless, and
the buyer of the call loses his
entire investment of '" .
Basic Put Option Profit Profiles
• If the put is in-the-money, it
is worth # − !! .
• The maximum gain is # − (" .
• If the put is out-of-the-
money, it is worthless, and
the buyer of the put loses his
entire investment of (" .
Problem 1
Solution 1
• If the spot exchange rate turns out to be $1.60/£ on the maturity
date, this put option will be out-of-the-money.
• Since there is no point to exercising the put option and selling pounds
for $1.45 when the pounds can be sold for $1.60 on the spot market,
you will not exercise this option.
• If the spot exchange rate turns out to be $1.40/£ on the maturity
date, this put option will be in-the-money.
• Since you can sell pounds $1.45 by exercising the put option when
pounds are worth $1.40 on the spot market, you will exercise this
option.
Problem 2
Solution 2
a. If you take a long position on this call option, your maximum possible
profit is unlimited since there is no theoretical limit to how high
exchange rates can go.
b. If you take a long position on this call option, your maximum possible
loss is the call premium of $0.05/AUD or -$500 for one contract (-
$0.05/AUD × AUD10,000 = -$500). As a buyer of this call option, you do
not exercise if it is to your disadvantage and simply let the contract
expire.
c. If you are a call writer, your maximum possible profit is the premium of
$0.05/AUD or $500 for one contract.
d. If you are a call writer, your maximum possible loss is unlimited since
there is no limit to high how exchange rates can go.
Solution 2 (Continued)
e. The break-even exchange rate for this call option is at !! = # + ':
$0.75/AUD+$0.05/AUD=$0.80/AUD

That is, if the spot exchange rate turns out to be $0.80/AUD, the
buyer and seller neither makes money nor loses money.
American Option-Pricing Relationships
• American options will satisfy the following basic pricing relationships
at time t prior to expiration:
!! ≥ Max &$ − (, 0 +! ≥ Max ( − &$ , 0

• The above equations state that the American call and put premiums
at time t will be at least as large as the immediate exercise value, or
the intrinsic value, of the call or put option
• A longer-term American option will have a market price at least as
large as the short-term option.
American Option-Pricing Relationships
• Difference between the option premium and the option’s intrinsic
value is nonnegative and is sometimes referred to as the option’s
time value.
• For example, the time value for an American call option is:
!! − Max &$ − (, 0

• The time value exists because the option may move more in-the-
money, and thus become more valuable, as time elapses.
Market Value, Time Value, and Intrinsic Value
of an American Call Option
European Option-Pricing Relationships
• Pricing boundaries for European put and call premiums are more complex.
• Consider two portfolios:
• Portfolio A involves purchasing a European call option (with exercise price % and
premium &! ) and lending (or investing) an amount equal to the present value of
the exercise price, E, at the U.S. interest rate, '$ , which we assume corresponds to
the length of the investment period.
• Cost of this investment is: !! + #/(1 + '$ )
• Payoffs of the call option:
• If #! ≤ %, call owner will let call option expire worthless.
• If #! > %, call owner will exercise the call, and exercise value will be #! − % > 0.
• Payoffs of the risk-free loan:
• % regardless of which state occurs at time ).
#, ,# ≤ #
Payoff of the Por8olio A = *
,# , ,# > #
European Option-Pricing Relationships
• Consider two portfolios (continued):
• Portfolio B consists of lending the present value of one unit of foreign currency, (,
at the foreign interest rate, '* , which we assume corresponds to the length of the
investment period.
• Cost of this investment is: S$ /(1 + '% )
,# , ,# ≤ #
• Payoffs of the risk-free loan: Payoff of the Por8olio B = *
,# , ,# > #
• #! regardless of which state occurs at time ).

• If )+ > %, portfolio A and B pay off the same amount, )+ , however, if )+ ≤ %,

portfolio A has a larger payoff than portfolio B.
• Therefore, portfolio A will be priced to sell for at least as much as portfolio B:
&! + %/(1 + '$ ) ≥ ), /(1 + '* )
European Option-Pricing Relationships
• In a rational marketplace, portfolio A will be priced to sell for at least
as much as portfolio B, and the European call can never sell for a
negative amount.
), %
&! ≥ Max − ,0
(1 + '* ) (1 + '$ )

• Similarly, it can be shown that the lower boundary pricing relationship

for a European put is:
% ),
8! ≥ Max − ,0
(1 + '$ ) (1 + '* )
Equation for a European Call Option Lower
Boundary
Current Time Expiration
,# ≤ # ,# > #
Portfolio A:
Buy Call −!! 0 ,# − #
Lend PV of # at '$ −#/(1 + '$ ) # #
Payoffs −!! − #/(1 + '$ ) # ,#
Portfolio B:
Lend PV of one unit of
−,& /(1 + '% ) ,# ,#
currency 2 at rate '%
Payoffs −,& /(1 + '% ) ,# ,#
European Option-Pricing Relationships
), % % ),
&! ≥ Max − ,0 8! ≥ Max − ,0
(1 + '* ) (1 + '$ ) (1 + '$ ) (1 + '* )

Based on these two equations, it can be determined that, when all else
remains the same, the call premium *# (put premium, +# ) will increase:
• The larger (smaller) is the exchange rate, !$ .
• The smaller (larger) is the exercise price, #.
• The smaller (larger) is the foreign interest rate, ,% .
• The larger (smaller) is the dollar interest rate, ,$ .
• The larger (smaller) ,$ is relative to ,% .
 European Option-Pricing Relationships
• From the IRP relationship, -! = !$ (1 + ,$ )/ 1 + ,% , European call
and put prices on spot foreign exchange can be restated as:
3#
(1 + '$ )
), % (9+ − %)
&! ≥ Max − ,0 &! ≥ Max ,0
(1 + '* ) (1 + '$ ) (1 + '$ )

% ), (% − 9+ )
8! ≥ Max − ,0 8! ≥ Max ,0
(1 + '$ ) (1 + '* ) (1 + '$ )
Problem 3
Solution 3
• Intrinsic value of an American call option: Max $" − &, 0
• "$ = 92.04; ) = 93;
• Max 92.04 − 93, 0 = 0
• Intrinsic value of an American put option: Max & − $" , 0
• Max 93 − 92.04, 0 = 0.96 cents per 100 yen.
• Time value of an American call option: )# − Max $" − &, 0
• !! = 2.10
• Time value = 2.10 − Max 92.04 − 93, 0 = 2.10 cents per 100 yen.
• Time value of an American put option: *# − Max & − $" , 0
• 3! = 2.20
• Time value = 2.20 − Max 93 − 92.04, 0 = 1.24 cents per 100 yen.