Foreign currency options can be purchased or sold in three different types of markets:
1. Options on the physical currency, purchased on the over-the-counter (interbank) market;
2. Options on the physical currency, purchased on an organized exchange such as the Philadelphia Stock Exchange; and
3. Options on futures contracts, purchased on the International Monetary Market (IMM).
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B.1. Options on the Over-the-Counter Market
Over-the-counter (OTC) options are most frequently written by banks for U.S. dollars against British pounds, German marks, Swiss francs, Japanese yen, and Canadian dollars. They are usually written in round lots of $85 to $10 million in New York and $2 to 83 million in London. The main advantage of over-the-counter options is that they are tailored to the specific needs of the firm. Financial institutions are willing to write or buy options that vary by amount (national principal), strike price, and maturity. Although the over-the-counter markets were relatively illiquid in the early years, the market has grown to such proportions that liquidity is now considered quite good. On the other hand, the buyer must assess the writing bank’s ability to fulfill the option contract. Termed counterparty risk, the financial risk associated with the counterparty is an increasing issue in international markets. Exchange- traded options are more the sphere of the financial institutions themselves. A firm wishing to purchase an option in the over-the-counter market normally places a call to the currency option desk of a major money center bank, specifies the currencies, maturity, strike rate(s), and asks for an indication, a bid-offer quote.
B.2. Options on Organized Exchanges
Options on the physical (underlying) currency are traded on a number of organized exchanges worldwide, including the Philadelphia Stock Exchange (PHLX) and the London International Financial Futures Exchange (LIFFE). Exchange-traded options are settled through a clear- inghouse, so that buyers do not deal directly with sellers. The clearinghouse is the counterparty to every option contract and it guarantees fulfillment. Clearinghouse obligations are in turn the obligation of all members of the exchange, including a large number of banks. In the case of the Philadelphia Stock Exchange, clearinghouse services are provided by the Options Clearing Corporation (OCC).
The Philadelphia Exchange has long been the innovator in exchange-traded options and has in recent years added a number of unique features to its United Currency Options Market (UCOM) making exchange-traded options much more flexible—and more com- petitive—in meeting the needs of corporate clients. UCOM offers a variety of option products with standardized currency options on eight major currencies and two cross- rate pairs (non-U.S. dollar), with either American- or European-style pricing. The exchange also offers customized currency options, in which the user may choose exercise price, expiration date (up to two years), and premium quotation form (units of currency or percentage of underlying value). Cross-rate options are also available for the DM/¥
and £/DM. By taking the U.S. dollar out of the equation, cross-rate options allow one to hedge directly the currency risk that arises in dealing with nondollar currencies.
Contract specifications are shown in Exhibit 21. The PHLX trades both American-style and European-style currency options. It also trades month-end options (listed as EOM, or end of month), which ensures the availability of a short-term (at most, a two- or sometimes three-week) currency option at all times and long-term options, which extend the available expiration months on PHLX dollar-based and cross-rate contracts providing for 18- and 24-month European-style options. In 1994, the PHLX introduced a new option contract, called the Virtual Currency Option, which is settled in U.S. dollars rather than in the underlying currency.
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B.3. Currency Option Quotations and Prices
Some recent currency option prices from the Philadelphia Stock Exchange are presented in Exhibit 22. Quotations are usually available for more combinations of strike prices and expiration dates than were actually traded and thus reported in the newspaper such as the Wall Street Journal. Exhibit 22 illustrates the three different prices that characterize any foreign currency option. Note: Currency option strike prices and premiums on the U.S. dollar are quoted here as direct quotations ($/DM, $/¥, etc.) as opposed to the more common usage of indirect quotations used throughout the book. This approach is standard practice with option prices as quoted on major option exchanges like the Philadelphia Stock Exchange.
EXHIBIT 21
Philadelphia Stock Exchange Currency Option Specifications
Austrian Dollar
British Pound
Canadian Dollar
Deutsche
Mark Swiss Franc Euro
Japanese Yen Symbol
American XAD XBP XCD XDM SXF XEU XJY
European CAD CBP CCD CDM CSF ECU CJY
Contract size A$50,000 £31,250 C$50,000 DM 62,500 SFr 62,500 €62,500 ¥6,250,000 Exercise Price
Intervals
1¢ 2.5¢ 0.5¢ 1¢1 1¢1 2¢ 0.01¢1
Premium Quotations
Cents per unit
Cents per unit
Cents per unit
Cents per unit
Cents per unit
Cents per unit
Hundredths of a cent per unit Minimum Price
Change
$0.(00)01 $0.(00)01 $0.(00)01 $0.(00)01 $0.(00)01 $0.(00)02 $0.(00)01 Minimum
Contract Price Change
$5.00 $3.125 $5.00 $6.25 $6.25 $6.25 $6.25
Expiration Months
March, June, September, and December + two near-term months Exercise Notice No automatic exercise of in-the-money options
Expiration Date Friday before third Wednesday of the month (Friday is also the last trading day) Expiration
Settlement Date
Third Wednesday of month Daily Price
Limits
None Issuer &
Guarantor
Options Clearing Corporation (OCC) Margin for
Uncovered Writer
Option premium plus 4% of the underlying contract value less out-of-money amount, if any, to a minimum of the option premium plus % of the underlying contract value.
Contract value equal spot price times unit of currency per contract.
Position &
Exercise Limits
100,000 contracts
Trading Hours 2:30 A.M.−2:30 P.M. Philadelphia time, Monday through Friday2 Taxation Any gain or loss: 60% long-term/40% short-term
1 Half-point strike prices (0.5¢) for SFr (0.5¢), and ¥ (0.005¢) in the three near-term months only.
2 Trading hours for the Canadian dollar are 7:00 A.M.–2:30 P.M. Philadelphia time, Monday through Friday.
Source: Adapted from Standardized Currency Options Specifications, Philadelphia Stock Exchange, May 2000.
(http://www.phlx.com/products/standard.html)
3/4
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The three prices that characterize an “August 48 1/2 call option” are the following:
1. Spot rate. In Exhibit 22, “option and underlying” means that 48.51 cents, or
$0.4851, was the spot dollar price of one German mark at the close of trading on the preceding day.
2. Exercise price. The exercise price or “strike price” listed in Exhibit 22 means the price per mark that must be paid if the option is exercised. The August call option on marks of 48 1/2 means $0.4850/DM. Exhibit 22 lists nine different strike prices, ranging from $0.4600/DM to $0.5000/DM, although more were available on that date than are listed here.
3. Premium. The premium is the cost or price of the option. The price of the August 48 1/2 call option on German marks was 0.50 U.S. cents per mark, or $0.0050/DM.
There was no trading of the September and December 48 1/2 call on that day. The premium is the market value of the option. The terms premium, cost, price, and value are all interchangeable when referring to an option. All option premiums are expressed in cents per unit of foreign currency on the Philadelphia Stock Exchange except for the French franc, which is expressed in tenths of a cent per franc, and the Japanese yen, which is expressed in hundredths of a cent per yen.
The August 48 1/2 call option premium was 0.50 cents per mark, and in this case, the August 48 1/2 put premium was also 0.50 cents per mark. As one option contract on the Philadelphia Stock Exchange consists of 62,500 marks, the total cost of one option contract for the call (or put in this case) is DM62,500 × $0.0050/DM = $312.50.
B.4. Speculating in Option Markets
Options differ from all other types of financial instruments in the patterns of risk they produce.
The option owner has the choice of exercising the option or allowing it to expire unused.
The owner will exercise it only when exercising is profitable, which means when the option is in the money. In the case of a call option, as the spot price of the underlying currency moves up, the holder has the possibility of unlimited profit. On the downside, however, the holder can abandon the option and walk away with a loss never greater than the premium paid.
EXHIBIT 22
Foreign Currency Option Quotations (Philadelphia Stock Exchange)
Option and
Underlying Strike Price
Calls—Last Puts—Last
Aug. Sept. Dec. Aug. Sept. Dec.
62.500 German marks
Cents per unit
48.51 46 — — 2.76 0.04 0.22 1.16
48.51 46 1/2 — — — 0.06 0.30 —
48.51 47 1.13 — 1.74 0.10 0.38 1.27
48.51 47 1/2 0.75 — — 0.17 0.55 —
48.51 48 0.71 1.05 1.28 0.27 0.89 1.81
48.51 48 1/2 0.50 — — 0.50 0.99 —
48.51 49 0.30 0.66 1.21 0.90 1.36 —
48.51 49 1/2 0.15 0.40 — 2.32 — —
48.51 50 — 0.31 — 2.32 2.62 3.30
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