Currency Options [Compatibility Mode]

7/29/2019 Currency Options [Compatibility Mode]

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Key Points : Slides 2 to 30

Full Presentation: Slides 29 to 78

Currency Options 1

Unlike forwards which lock on to a rate,options have flexibility, for which the optionbuyer pays a premium to the option seller

Buyer puts up no margin, seller must put upa margin

Right but not the obligation to deliver Call ( the option to buy) and put ( the option

to sell ) Strike ( or exercise ) price Time to maturity European and American style options

Currency Options 2

The floor is to protect you from belowagainst low exchange rates when selling

the effect of a Put

The ceiling is to protect you from aboveagainst high exchange rates when buying

the effect of a Call

Currency Options 3

Call = max(S-X;0) - Premium

Break Even at S-X = P S = X+P

(X+P) is the ceiling for currency exchange risksince holder can always buy at X

Currency Options 4


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Put = max(X-S;0) Premium

Break Even at X-S = P or S = X-P

(X-P) is the floor for currency exchange risksince holder can always sell for X

Currency Options 5 Currency Options 6

Writing a call

X

C

SX

C

S

Buying a call

Currency Options 7

X

P

S

Buying a put

X

P

S

Writing a put

Is a function of the following factors:

Spot price

Strike price

Time to expiration

Volatility

Interest differential between the twocurrencies

Currency Options 8


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TenureTenureTenureTenure At the MoneyAt the MoneyAt the MoneyAt the MoneyForward (ATMF )Forward (ATMF )Forward (ATMF )Forward (ATMF )Strike Price ( Rs.Strike Price ( Rs.Strike Price ( Rs.Strike Price ( Rs.

Per USD)Per USD)Per USD)Per USD)

Premium in INR (Premium in INR (Premium in INR (Premium in INR (Contract AmountContract AmountContract AmountContract Amount

USD 1 Million)USD 1 Million)USD 1 Million)USD 1 Million)

1 Month1 Month1 Month1 Month 53.490053.490053.490053.4900 12250122501225012250

3 Months3 Months3 Months3 Months 54.200054.200054.200054.2000 21000210002100021000

6 Months6 Months6 Months6 Months 55.110055.110055.110055.1100 30000300003000030000

1 Year1 Year1 Year1 Year 56.700056.700056.700056.7000 43000430004300043000

Currency Options 9

Premia on Rupee Dollar options at Spot Reference

Rs. 53.19 ( 2 February 2013)

Currency Options 10



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Currency Options 13

Call should be worth more than intrinsic valuewhen out of the money

Call should be worth more than intrinsic valuewhen in the money

Call should never be worth more than theprice of the underlying asset

Currency Options 14

Prices or premia for options are arrived atthrough open competition between buyersand sellers on the floor of the exchange

Players normally use, for their own guidance,

mathematical models such as the Black-Sholes option pricing model

Essentially, the value of an option is theexpected value of a probability distribution (see next slide for a simple illustration )

Currency Options 15

3000

2500

2000

1500

1000

500

45 45 .50 46 46 .50 47 4 7.50 48

(RUPEES PER DOLLAR)

CONTRACTCONTRACTCONTRACTCONTRACT SIZE $1SIZE $1SIZE $1SIZE $1 MILLION,MILLION,MILLION,MILLION, CALLCALLCALLCALL OPTION ATOPTION ATOPTION ATOPTION AT RRRRssss. 45/. 45/. 45/. 45/---- WHICHWHICHWHICHWHICH ISISISIS

ALSO THEALSO THEALSO THEALSO THE SPOTSPOTSPOTSPOT PRICEPRICEPRICEPRICE ( OR THE( OR THE( OR THE( OR THE MEANMEANMEANMEAN OF THEOF THEOF THEOF THE DISTRIBUTION)DISTRIBUTION)DISTRIBUTION)DISTRIBUTION)

This and the nextslide are purelyillustrative


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Spot RangeSpot RangeSpot RangeSpot Range Payoff RangePayoff RangePayoff RangePayoff Range( Rs.000)( Rs.000)( Rs.000)( Rs.000)

ProbabilityProbabilityProbabilityProbability ofofofofOccurrenceOccurrenceOccurrenceOccurrence

Contribution ofContribution ofContribution ofContribution ofExpected ProfitExpected ProfitExpected ProfitExpected Profit

(Rs.000)(Rs.000)(Rs.000)(Rs.000)

45454545 ---- 45.5045.5045.5045.50 0000 500500500500 0.190.190.190.19 250 * 0.19 = 47.5250 * 0.19 = 47.5250 * 0.19 = 47.5250 * 0.19 = 47.5

45.5045.5045.5045.50 46464646 500500500500 1000100010001000 0.150.150.150.15 750 * 0.15 = 112.5750 * 0.15 = 112.5750 * 0.15 = 112.5750 * 0.15 = 112.5

46464646 46.5046.5046.5046.50 1000100010001000 1500150015001500 0.090.090.090.09 1250 * 0.09 = 112.51250 * 0.09 = 112.51250 * 0.09 = 112.51250 * 0.09 = 112.5

46.5046.5046.5046.50 47474747 1500150015001500 2000200020002000 0.050.050.050.05 1750 * 0.05 = 87.51750 * 0.05 = 87.51750 * 0.05 = 87.51750 * 0.05 = 87.5

47474747 47.5047.5047.5047.50 2000200020002000 2500250025002500 0.010.010.010.01 2250 * 0.01 = 22.52250 * 0.01 = 22.52250 * 0.01 = 22.52250 * 0.01 = 22.5

47.5047.5047.5047.50 48484848 2500250025002500 ---- 3000300030003000 .01.01.01.01 2750 * 0.01 = 27.52750 * 0.01 = 27.52750 * 0.01 = 27.52750 * 0.01 = 27.5

Expected ProfitExpected ProfitExpected ProfitExpected Profit 410.0410.0410.0410.0

(PROBABILITY DISTRIBUTION(PROBABILITY DISTRIBUTION(PROBABILITY DISTRIBUTION(PROBABILITY DISTRIBUTION)

Call options -

closing spot price > strike price

Put options

closing spot price < strike price

Currency Options 18

By definition, an American call option can beexercised early.

Early exercise of an American option is

generally undesirable. Why? You might have heard the following proverbs:

An option is always worth more alive than dead.

Always exercise your options as late as possible.

Currency Options 19

A Call on high interest currencies and a Put onlow interest are most likely to be exercised

Option value increases with foreign currency

volatility b.o. larger probability of optionbeing valuable (in the money)

Currency Options 20


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Time value can be divided into twocomponents:

The financing cost = X X / ( 1 + r ) tothe power t, where X is the strike price andr is the interest rate

Volatility value, which is influenced bymarket expectations of volatility. The latteris not linearly related with time

Currency Options 21

An option is a wasting asset

Its sole value at expiration is its intrinsicvalue, if any, and not time value

Time value decays at a faster pace as theexpiry date approaches

Time value is related to the square root of

the time remaining before expiry

Currency Options 22

Currency Options 23

Time value decay

Timevalue

Time Expiry date

Time valuedecays faster asthe expiry dateapproaches

This parity condition relates option pricesto the interest differential, and byextension, to the forward differential

This parity can be expressed algebraically

as shown on the next slide

Currency Options 24


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Currency Options 25

Put-call parity

C = P + ------------------------F1 - X

1 + rh

Where:C = the call option premiumP = the put option premium

X = the strike priceF1 = the forward rate , andRh = domestic interest rate

Continued from previous slide:

To put it in words, rather than symbols:

A long call = A long put + a forward ( or afutures )

Currency Options 26

Option prices depend critically on theestimate of volatility being used

Traders often use the implied volatility, whichis the volatility that yields the market price of

the option , when substituted in the optionpricing formula

Currency Options 27

Traders use implied volatility as an indicationof the markets opinion of future exchangerate volatility

Implied volatilities function for options in the

same way as yields to maturity for bonds

Currency Options 28


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For volatile currencies, one possiblespeculative strategy is to purchase astraddle, which represents both a putoption and a call option at the sameexercise price.

By purchasing both options, the speculatormay gain if the currency moves

substantially in either direction, or if itmoves in one direction, followed by theother


SX2X1

C

Buy the low exercise price call

and

sell the high exercise price call

Currency Options 31

SX2X1

C

Sell the low exercise price call

and

buy the high exercise price call

Currency Options 32


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Options are as old as civilization. Option tobuy a piece of land in the city

Chicago Board Options Exchange, a spinofffrom the Chicago Board of Trade 1973,traded first standardized options

American Stock Exchange 1974, NYSE 1982

Currency Options 33

A currency option provides the buyer with theright but not the obligation, to buy or sell aset amount of currency at an agreedexchange rate, known as the strike price orstrike price orstrike price orstrike price orthe exercise pricethe exercise pricethe exercise pricethe exercise price

Currency Options 34

A call option gives the option buyer the rightto buy an agreed amount of the specifiedcurrency at the strike price

Currency Options 35

A put option gives the option buyer the rightto sell an agreed amount of the specifiedcurrency at the strike price

Currency Options 36


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Exercise date

Exercise price

Definition of underlying and amount ofcurrency

Currency Options 37

For every option there is both a buyer and awriter

The buyer pays a premium to the writer forthe ability to choose when to exercise, andthe writer must abide by buyers choice

Buyer puts up no margin, writer must put upa margin

Currency Options 38

The floor is to protect you from belowagainst low exchange rates when selling

the effect of a Put

The ceiling is to protect you from aboveagainst high exchange rates when buying

the effect of a Call

Currency Options 39

Call = max(S-X;0) - Premium

Break Even at S-X = P S = X+P

(X+P) is the ceiling for currency exchange risksince holder can always buy at X

Currency Options 40


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Put = max(X-S;0) Premium

Break Even at X-S = P or S = X-P

(X-P) is the floor for currency exchange risksince holder can always sell for X

Currency Options 41

The option buyer ( or the holder ) pays to theoption seller an option premium for theflexibility provided by the option contract

Currency Options 42

A European style option can be exercised onlyon the date of maturity,

Whereas

An American style option can be exercised

any time during the contract period

Currency Options 43

What are some reasons why options mightlook attractive to hedgers ?

Currency Options 44


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Options are beneficial for hedging futurepotential transactions because of thenon-obligation provision, unlikeforwards or futures ( in the case of anopen short position in futures )

Options have a market price, in the formof an option premium, unlike forwardsor futures.

Currency Options 45

Continued from previous slide

Exercise price (X) and the Premium (P)determines the floor or ceiling

(assuming no fees on selling or exercisingand no time effect of premium being paidinitially)

Currency Options 46

Companies that use options to hedge futureforeign currency cash flows, would preferEuropean style options or American styleoptions ?

Currency Options 47

For firms that purchase options to hedgefuture foreign currency cash flows, the loss interms of the flexibility provided by anAmerican option is perhaps not an issue

Hence, if premiums are lower, European-stylecurrency options may be preferred

Currency Options 48


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Maximum gain Maximum loss

Calloption

Prevailing spot strike price the optionpremium

The optionpremium

Putoption

Strike price prevailing spot the optionpremium

The optionpremium

Currency Options 49

Maximumgain

Maximum loss

Call option The optionpremium

Prevailing spot strike price theoption premium

Put option The optionpremium Strike price prevailing spot the optionpremium

Currency Options 50

Currency Options 51

Writing a call

X

C

SX

C

S

Buying a call

Currency Options 52

X

P

S

Buying a put

X

P

S

Writing a put


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Is a function of the following factors:

Spot price

Strike price

Time to expiration

Volatility Interest differential between the two

currencies

Currency Options 55

It is clear that as S increases, so does C, thevalue of a call option. A call option is said to

be in the money ifS> X. Conversely, as Xincreases, Cdecreases.

What is the effect ofs increasing? Cincreases. Longer the time to expiration, more the worth

of a call.(contd..next slide )

Currency Options 56

( )C f S X r T s f= , , , ,


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Call should be worth more than intrinsic valuewhen out of the money

Call should be worth more than intrinsic valuewhen in the money

Call should never be worth more than theprice of the underlying asset

Currency Options 61

Call options -

closing spot price > strike price

Put options

closing spot price < strike price

Currency Options 62

By definition, an American call option can beexercised early.

Early exercise of an American option isgenerally undesirable. Why?

You might have heard the following proverbs: An option is always worth more alive than dead.

Always exercise your options as late as possible.

Currency Options 63

Prices or premia for options are arrived atthrough open competition between buyersand sellers on the floor of the exchange

Players normally use, for their own guidance,

mathematical models such as the Black-Sholes option pricing model

Currency Options 64


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The premium quoted represents a consensusopinion on the options current value, whichconsists normally of the following twoelements :

Intrinsic value, and

The time value

Currency Options 65

The intrinsic value of an option is theamount by which an option is currently inthe money, which means that

The prevailing spot is greater than thestrike price, in the case of a call option, and

The converse in the case of a put option

Currency Options 66

Refers to the sum of money which optionbuyers are willing to pay over and above theintrinsic value. Time value lies in theprobability that :

An option which is currently out-of-themoney might become in the money, or

An option which is currently in the moneymight become more in the money

Currency Options 67

Intrinsic value Time value

Calloption

= Prevailing spot strike price

Intrinsic value iszero, if theprevailing priceis less than thestrike price

Positivelyaffected by :

Time tomaturity

Volatility

Domestic-foreign interestratedifferentialCurrency Options 68


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Intrinsic value Time value

Putoption

= Strike price prevailingspot

Intrinsic valueis zero if thestrike price isless than theprevailing spot

Positivelyaffected by:

Time to

maturityVolatility

Domestic-foreign interestrate differential

Currency Options 69

A Call on high interest currencies and a Put onlow interest are most likely to be exercised

Option value increases with foreign currencyvolatility b.o. larger probability of optionbeing valuable (in the money)

Currency Options 70

Time value can be divided into twocomponents:

The financing cost = X X / ( 1 + r ) tothe power t, where X is the strike price and

r is the interest rate Volatility value, which is influenced by

market expectations of volatility. The latteris not linearly related with time

Currency Options 71

An option is a wasting asset

Its sole value at expiration is its intrinsicvalue, if any, and not time value

Time value decays at a faster pace as the

expiry date approaches Time value is related to the square root of

the time remaining before expiry

Currency Options 72


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Currency Options 73

Time value decay

Timevalue

Time Expiry date

Time valuedecays faster asthe expiry dateapproaches

This parity condition relates option pricesto the interest differential, and byextension, to the forward differential

This parity can be expressed algebraicallyas shown on the next slide

Currency Options 74

Currency Options 75

Put-call parity

C = P + ------------------------F1 - X

1 + rh

Where:C = the call option premiumP = the put option premium

X = the strike priceF1 = the forward rate , andRh = domestic interest rate

Continued from previous slide:

To put it in words, rather than symbols:

A long call = A long put + a forward ( or afutures )

Currency Options 76


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Option prices depend critically on theestimate of volatility being used

Traders often use the implied volatility, whichis the volatility that yields the market price ofthe option , when substituted in the optionpricing formula

Currency Options 77

Traders use implied volatility as an indicationof the markets opinion of future exchangerate volatility

Implied volatilities function for options in thesame way as yields to maturity for bonds

Currency Options 78

For volatile currencies, one possiblespeculative strategy is to purchase astraddle, which represents both a putoption and a call option at the sameexercise price.

By purchasing both options, the speculatormay gain if the currency movessubstantially in either direction, or if itmoves in one direction, followed by theother


SX2X1

C

Buy the low exercise price call

and

sell the high exercise price call


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Currency Options 81

SX2X1

C

Sell the low exercise price call

and

buy the high exercise price call

Currency Options [Compatibility Mode]

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