Lecture International finance: An analytical approach (3/e): Chapter 10 - Imad A. Moosa

Chapter 10 - Currency options. In this chapter, the learning objectives are: To introduce basic concepts, to outline the differences between OTC and exchange-traded options, to describe option positions, to identify the determinants of option premiums, to describe exotic currency options.

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Chapter 10

Currency Options

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa

Slides prepared by Afaf Moosa

Objectives

• To introduce basic concepts

• To outline the differences between OTC and

exchange-traded options

• To describe option positions

• To identify the determinants of option premiums

• To describe exotic currency options

10-2

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Definition

• A currency option is a contract that gives its holder the right to buy or sell, on or by a specified date, an amount of a currency at a predetermined exchange rate

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Options writers and holders

• The writer sells the holder the right to buy or sell the underlying currency

• The price paid up front is called the premium

10-4

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Payment and settlement dates

• The premium payment date is the date on which the premium is due

• The settlement date is the date on which delivery of the underlying currency is required

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Call and put options

• A call option gives the holder the right to buy the

underlying currency

• A put option gives the holder the right to sell the

underlying currency

10-6

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The mechanics of call and put

options on the Australian dollar

USD

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Naked and covered options

• An option is naked if there is no corresponding spot position on the underlying currency

10-8

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The exercise (strike) exchange rate

• The exchange rate at which the holder of the option can buy or sell the underlying currency

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Profitable exercise of call and put on

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Profitable exercise of call and put options on the Australian dollar

AUD 1,000,000 Holder

Spot market

Writer

Holder

E= 0.60

Spot market

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The settlement exchange rate

• The exchange rate at which the underlying currency can be bought or sold when the option is exercised

10-12

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Net settlement payments on

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Long and short positions

• The holder of an option has a long position

• The writer of an option has a short position

10-14

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Expiry date

• The date by or on which the option can be exercised

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American and European options

• An American option can be exercised before or on

the expiry date

• A European option can be exercised on the expiry

date only

10-16

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In the money and out of the money

• An option is in the money if it can be exercised at

gross profit

• An option is out of the money if it cannot be

exercised at gross profit

• An option is at the money if the spot rate is equal to the exercise rate

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Intrinsic value and time value

• The intrinsic value is the extent to which the option is

in the money

• The time value is derived from the possibility that

with the passage of time the option will be in the

money

10-18

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• An assignment materialises when the writer receives

a notice that the holder has exercised the option, in which case the writer is obliged to deliver or receive the underlying currency

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Base and underlying currencies

• The base currency is the currency in which the

option price is expressed

• The underlying currency is the currency that is

bought or sold

10-20

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• A margin is the cash or securities required to be

deposited by an option writer as collateral

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Open Interest

• Open interest is the number of outstanding options

10-22

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Opening and closing transactions

• An opening transaction results in opening a new

position

• A closing transaction results in liquidating an existing position

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Registered options traders

• ROTs are participants on the exchange, trading for

their own or their firm’s account

10-24

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Option quotations

• American terms mean that the underlying exchange rate is quoted in terms of the US dollar per unit of the other currency

• European terms mean that the underlying exchange rate is quoted in terms of the other currency per unit

of the US dollar

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OTC and exchange-traded options

• An OTC option is non-standardised, created by the writer to meet the specific requirements of the buyer

• An exchange-traded option is a standardised option traded on an exchange

10-26

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Currency option specifications

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Differences between OTC and

exchange-traded options

• The counterparty to every transaction on an

organised exchange is the clearing corporation In

the OTC market it is another trader

• Prices are visible in an organised exchange but are

not in the OTC market

10-28

(cont.)

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Differences between OTC and

exchange-traded options (cont.)

• Margins are required for short positions in an

organised exchange but are not in the OTC market

• Positions must be marked on a daily basis in an

organised exchange but this is not the case in the

OTC market

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Currency options traded on the

Philadelphia stock exchange

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Actions and gross payoffs

exercised 0 Short call Not

exercised 0 Exercised ( E S ) Short put Exercised ( S E ) Not

exercised 0

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Net pay-offs on option positions

• Net pay-offs take the premium into account For

example, the net pay-off on a long call is:

S -E - R

10-32

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Long straddle

• Obtained by buying call A and buying put A It is used when the currency is expected to appreciate or

depreciate dramatically

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Short straddle

• Obtained by selling call A and selling put A It is used when the currency is not expected to move much

10-34

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Long strangle

• Can be obtained by buying call B and buying put A It

is cheaper than a straddle

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Short strangle

• Can be obtained by selling put A and selling call B

10-36

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Long call

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Long put

10-38

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Long straddle

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Short call

10-40

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Short put

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Short straddle

10-42

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Long strangle

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Short strangle

10-44

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Factors determining option prices

• Exercise exchange rate

• Time to expiry

• Intrinsic value

• Exchange rate volatility

(cont.)

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Factors determining option prices (cont.)

• Type of option

• Interest rate on the base currency

• Forward spread and interest rate differential

10-46

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Measures of sensitivity

exchange rate

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Exotic options

• Exotic options are European-style options that offer

alternative pricing, timing or exercise provisions to

those of ‘conventional’ options

10-48

(cont.)

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Exotic options (cont.)

• The knockout option is also known as down-and-out option, barrier option, extinguishable option and

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• The value of a path-dependent option depends on

the average value of the spot exchange rate over a

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• A chooser option allows the buyer to lock in (in

advance) a specific exercise exchange rate, amount and maturity At a later date the choice is made

between making the option a call or a put

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