This publication should not be construed as a solicitation or offering of advice for the purpose of buying or selling any financial product. The author has tried to be as accurate as possible with the information presented here, it does not guarantee the accuracy or completeness of the information and makes no warranty of merchantability or fitness for a particular purpose.
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THE FORWARD FOREIGN EXCHANGE MARKET
The forex market was developed to help companies protect themselves against some of the uncertainty of exchange rate movements, but forex is really appropriate for known exposures. This has therefore in part led to the expansion of the currency options market, which has been even more spectacular than the tremendous growth seen in the entire currency market over the past decade or so.
THE CURRENCY OPTIONS MARKET
THE ALTERNATIVES TO CURRENCY OPTIONS
THE USERS
WHOSE DOMAIN?
Foreign Exchange or FX or Forex are all claims to foreign currency payable abroad, whether consisting of funds held in foreign currency with banks abroad, or bills or checks payable abroad, i.e. A foreign exchange transaction is a contract to exchange one currency for another currency at an agreed rate on an agreed date.
TWENTY-FOUR-HOUR GLOBAL MARKET
VALUE TERMS
COFFEE HOUSES
SPOT AND FORWARD MARKET
The Foreign Exchange Market 7 These banks typically have large foreign exchange sales and trading departments that not only handle their customers' requests but also take positions to make trading profits and balance foreign currency positions from other banking activities. Typical transactions in the banking market range from $1 million to $500 million, although banks will settle smaller amounts, as requested by their customers, on slightly less favorable terms.
ALTERNATIVE MARKETS
CURRENCY OPTIONS
For example, a UK company looking to make an acquisition in Japan is faced with a possible uncertainty in the timing of a foreign currency cash flow. If it is hedged using a foreign exchange future, then there is potential for a realized loss when the forward contract is rolled.
CONCLUDING REMARKS
If the exchange rate moves in its favor, the company can trade at the better prevailing rate. However, if the company loses the contract, it will either have lost the premium, which is a known cost paid up front, or it may have the potential for profit if the prevailing exchange rate is better than the rate agreed under the option .
THE BARTER SYSTEM
THE INTRODUCTION OF COINAGE
9,000 to 6,000 B.C. Saw animals (cows, sheep, camels) are used as the first and oldest form of money. AD 800 was when the first paper banknotes appeared in China and as a result currency exchange between some countries began.
THE EXPANDING BRITISH EMPIRE
THE GOLD STANDARD
A Brief History of the Market 11 value of their dollar holdings falling in terms of gold, they could exchange dollars for gold. As long as the discipline of tying the value of each currency to the value of gold was maintained, the simple laws of supply and demand would dictate both the currency's valuation and the country's economy.
THE BRETTON WOODS SYSTEM
The amounts were relatively small by today's standards, and the trading centers tended to exist in isolation.
THE INTERNATIONAL MONETARY FUND AND THE WORLD BANK
In fact, this increased supply of dollars in Europe financed post-war reconstruction of Europe. During the 1950s, as the Western economies grew, the supply of dollars also grew and contributed to the reconstruction of post-war Europe.
THE DOLLAR RULES OK
While the amount of gold held in the US central reserves remained constant, the supply of dollar currency grew. However, events in the 1960s once again unsettled the currency markets and threatened to unravel the agreement.
SPECIAL DRAWING RIGHTS
In the years following the Bretton Woods agreement, recovery quickly got underway, trade expanded again, and foreign exchange trading, though primitive by today's standards, returned.
A DOLLAR PROBLEM
THE SMITHSONIAN AGREEMENT
THE SNAKE
THE DIRTY FLOAT
The collapse of the Herstatt and Franklin banks followed as a direct result of this change in the dollar's fortunes. Treasury Secretary Michael Blumenthal, in an effort to boost exports, repeatedly devalued the dollar.
THE EUROPEAN MONETARY SYSTEM
The Kippur War in the Middle East created a huge demand for dollars, and because oil was priced in dollars, the dollar soared and those who were used to selling dollars were sorely tested. In the mid-1970s, the dollar was again under pressure as a result of continuing deteriorating balance of payments figures.
THE EXCHANGE RATE MECHANISM
THE EUROPEAN CURRENCY UNIT
THE MAASTRICHT TREATY
THE TREATY OF ROME
Speculators made fortunes in currency trading, betting against the ability of central banks to manage exchange rates at odds with the divergent economies and policies of EMS members. Indeed, it is the speculators who provide most of the capital in the effort to revalue or devalue a currency, rather than the current reserves of central banks.
ECONOMIC REFORM
In August 1993, ERM intervention points were widened to 15% for most currencies, an admission by central banks to markets of their inability to dictate exchange rates. Periods of volatility are always accompanied by speculation, as the market tries to find an equilibrium value for each currency that reflects all the information in the market.
A COMMON MONETARY POLICY
January 2001, Greece became the twelfth country to join the European Union
- THE SINGLE CURRENCY
- CURRENCY OPTIONS
- CONCLUDING REMARKS
- GLOBAL MARKET
- NO PHYSICAL TRADING FLOOR
- A “PERFECT” MARKET
- THE MAIN INSTRUMENTS
- COMPARISON OF OPTIONS WITH SPOT AND FORWARDS
- THE DOLLAR’S ROLE
- WIDELY TRADED CURRENCY PAIRS
- CONCLUDING REMARKS
- GOVERNMENTS
- BANKS
- BROKERING HOUSES
- INTERNATIONAL MONETARY MARKET
- MONEY MANAGERS
- CORPORATIONS
- RETAIL CLIENTS
- OTHERS
- SPECULATORS
- TRADE AND FINANCIAL FLOWS
- MARKET MAKERS
- PRICE TAKERS
- A NUMBER OF ROLES
- A NUMBER OF ROLES – OPTIONS
- CONCLUDING REMARKS
About 84% of the world's foreign exchange business is conducted in these three major trading centers. Corporations are, in the final analysis, the real end users of the foreign exchange market.
7 Purposes
COMMERCIAL TRANSACTIONS
FUNDING
HEDGING
PORTFOLIO INVESTMENT
PERSONAL
MARKET MAKING
TRANSACTION EXPOSURE
TRANSLATION EXPOSURE
ECONOMIC EXPOSURE
CONCLUDING REMARKS
By doing this, the trader will recover the time value and intrinsic value of the option. However, the greater flexibility available in the OTC market allows some of the credit difficulties to be pursued and overcome.
VARIETY OF REASONS
- Example 1
- Example 3
If the exchange rate moves in the company's favor, the company will receive a windfall profit on their long dollar position. If the company enters into a forward contract, the company locks in an exchange rate for the delivery agreement.
HEDGING vs SPECULATION
An option is a contract between the buyer (or holder) of the option and the seller (or writer) of the option. The specified asset involved in the option contract is referred to as the underlying asset on which the option is written.
CALL OPTION
PUT OPTION
A put option holder has the right, but not the obligation, to sell an asset. The buyer of the put option has the right to deliver 6 million Swiss francs to the put option writer in exchange for 4 million francs divided by 1.50 francs per dollar from the option writer.
PARTIES AND THE RISKS INVOLVED
For example, consider a put option on the Swiss franc against the dollar expiring in three months for 6 million Swiss francs struck at an exchange rate of 1.5000 francs per share. dollar ($1,500/sfr). The writer of this put option is thus obligated to receive 6 million francs from the option holder in exchange for 4 million dollars at any time up to and including the three-month expiration date.
CURRENCY OPTION RISK/REWARD PERCEPTION
CURRENCY OR DOLLAR CALL OR PUT OPTION?
STRIKE PRICE AND STRIKE SELECTION
EXERCISING OPTIONS
AMERICAN AND EUROPEAN STYLE OPTIONS
An in-the-money option describes an option whose exercise price is more favorable than the current market price of the underlying asset. In-the-money=Spot price is below the strike price of the option. Out-of-the-money=Spot price is above the strike price of the option.
THE PREMIUM
For a dollar put (right to sell), Swiss franc call (right to buy) option, with a strike price of 1.5700, then the intrinsic value of the option is 0.0000 dollars against Swiss francs. Intrinsic value is the benefit to the holder of the option from the strike rate compared to the forward outright rate.
VOLATILITY
Thus intrinsic value is simply the amount the option would be worth at expiration, whereby a currency option has value at expiration by the amount the spot rate is higher than the strike price, and whereby a currency put option has value at expiration by the amount the spot rate is below the strike - the interest rate. Obviously, an option will not be worth more than the intrinsic value at expiration because there will be no intrinsic benefit to owning it.
BREAK-EVEN
Obtain the RIGHT Assume the OBLIGATION Put option on selling the dollars to buy the dollars. Similarly, in the OTC market, the settlement of options transactions and the credit risk inherent in each transaction are a matter between the financial institution and its counterparty.
EXCHANGE vs OVER-THE-COUNTER
Forex options can be traded on official exchanges or over the counter (OTC), i.e. Payout: when the option expires, it depends on the difference between the strike price and the market price.
STANDARDISED OPTIONS
Currency Options Market 65 For example, Bank A buys from Bank B a put price of 1.5700 EUR/USD for 10 million pounds with a maturity of six months.
CUSTOMISED OPTIONS
Premiums – premiums can be expressed in terms of the base currency per unit of the underlying currency or in percentages of the underlying currency (based on the contract size). Currently, position limits are set at 200,000 contracts on each side of the market (long calls and short puts or short calls and long puts) for each currency except the Mexican peso, which is 100,000 contracts.
FEATURES OF THE LISTED MARKET
The Currency Options Market 67 Contract Terms – an option strike price can be expressed in US terms or European terms (reverse terms). Delivery and settlement – PHLX trades currency options that are physically settled – the exchange of one currency for another.
COMPARISONS
All CME US FX options are exercisable until 19:00 CET on any business day on which the option is traded. For Brazilian real options, however, this deadline is 7:00 PM Central Time on the business day following the close of trading for expiring monthly options.
WHERE IS THE MARKET?
Currency Options Market 69 Exercise/Compulsion – on the CME, all in-the-money options are automatically exercised at expiration in the absence of instructions to the contrary.
CONCLUDING REMARKS
Although the formula for pricing options is complex, they are all based on the same principles. The best known of these is the Garman-Kohlhagen fit, which adequately allows for the two interest rates and the fact that a currency can trade at a forward premium or discount depending on the interest rate differential.
BASIC PROPERTIES
An increase in the strike price would therefore result in a decrease in the price of the call option. Furthermore, the present value of the strike price decreases as the time to maturity increases.
THEORETICAL VALUATION
Thus, the effect of the exercise price, X, on the value of the call option is direct. In the case of put options, a higher exercise price increases the profit from exercising the option.
BLACK–SCHOLES MODEL
The delta, or hedge ratio of the option, is the extent to which the option value will change with a movement in the underlying currency. While the delta is the first derivative of the price, gamma is the second one, or change in delta for each movement in the visible foreign exchange rate.
EXAMPLES OF OTHER MODELS
Plotted over a period of time, the distribution of prices takes on the characteristics of the. Such a spread is a key assumption of the Black-Scholes model, but with the foreign exchange markets in particular, it is a questionable one.
PRICING WITHOUT A COMPUTER MODEL
EDUCATED GUESS
THE PRICE OF AN OPTION
If the strike price of the option is more favorable than the current forward price, the option is considered to be in the money. Conversely, if the option had the same details, apart from being a pound call, it would be clearly out-of-the-money under the European definition, but as an American-style option it would be in-the-money relative to the spot price.
OPTION PREMIUM PROFILE
TIME VALUE AND INTRINSIC VALUE
An option is said to have intrinsic value where the strike price of the option is more favorable than the current market rate. However, when the strike price of the option is equal to the current future rate, the option is said to be in the money.
TIME TO EXPIRY
Intrinsic value is the benefit to the holder of the exercise interest option over the direct forward exchange rate. Also, an option with some intrinsic value is described as in-the-money, while an option with no intrinsic value is out-of-the-money.
VOLATILITY
If the spot is above the strike price of the option, the customer will exercise the option and the bank will be obligated to sell dollars and buy francs. The hedging costs for the option thus increase, and as volatility increases, the price of the option will increase.
STRIKE PRICE AND FORWARD RATES
INTEREST RATES
Of course, the dollar interest rate may remain the same, but the foreign currency interest rate may fall. Therefore, an increase in the dollar interest rate or a decrease in the foreign currency interest rate makes the put option strategy less attractive and the put premium will fall.
AMERICAN vs EUROPEAN
The effect on the interest rate difference and therefore on the value of the currency call option remains the same, but the premium increases. The reverse is true for currency put options, because an increase in dollar interest rates relative to foreign currency interest rates, given unchanged spot prices, will result in an increase in the forward value of the currency.
CONCLUDING REMARKS
When a trader buys an option whose interest rates are close and the call rate is expected to rise above the put rate; and 3. When a trader buys an out-of-the-money option with interest rates as in both.
14 The Greeks
DELTA
Delta can also be thought of as the estimated probability of exercise of the option. However, as the forward spot price moves, the option's delta will move in exactly the same way as before.
GAMMA
The magnitude of the movement of the delta given this movement of the underlying is the option's gamma by definition "gamma is the change in delta per change in the underlying". Gamma is least for deep out-of-the-money and deep-in-the-money options;
THETA
If the foreign exchange rate at that time is $1.5501/sfr, the option will most likely be exercised and the delta will be 100. If, at that second, the current foreign exchange rate moves to $1.5499/sfr , the option would not actually be exercised and delta would move to 0.
VEGA
The Greeks 93 In the formulation of rho, let 0pand 0rbe current values for the portfolio and underlying. Rho usually refers to the base currency interest rate (usually dollars) and phi relates to the traded currency interest rates (for example, Swiss franc or Japanese yen).
BETA AND OMEGA
Initially, the chart in Figure 15.1 represents a long position in the base currency of a currency pair. Similarly, a short position in the base currency can be shown in the chart in Figure 15.2.
PAYOFF DIAGRAM
PROFIT DIAGRAM
THE OPTION WRITER
PUT OPTION
In the case of put options, the option is called "out of the money" when the price of the currency pair is greater than the strike priceX (just the opposite in the case of call options). When the price of the currency pair is less than the strike priceX, the option is called in-the-money.
PUT OPTION WRITER
Also, this representation of the option position at expiration takes into account the price P paid for the option.
BASIC OPTION POSITIONS
If the spot exchange rate at maturity is equal to or lower than the strike, the option holder will not exercise and the premium will be preserved. Further, if the currency pair is sold, the graph will be as shown in Figure 15.14.
GRAPH ADDITION
PROFIT/LOSS PROFILES FOR TEN POPULAR OPTION STRATEGIES
CONCLUDING REMARKS
This should not be true for European call and put options, as the option holder does not have the right to exercise until the maturity date. Since American options have all the rights that European options have plus an early exercise right, an American option will be as valuable as a European option if the early exercise right is void and more valuable than a European option if the early exercise right is of value.
OPTION VALUES
Second, option prices should not allow for simple arbitrage, meaning that it should not be possible to buy an American call or put option and immediately exercise it for a profit greater than the price paid for the option. This means that increased uncertainty increases value, while a decreased present value of the strike price decreases value.
PUT/CALL PARITY CONCEPT
Thus, given the put/call parity, the put premium can be derived based on the strike price, the call premium and the forward exchange rate. Alternatively, the call option premium is derived based on the strike price, put premium and forward exchange rate.
SYNTHETIC POSITIONS
As can be seen from the above, it is always possible to convert calls into puts and vice versa, through a forward foreign exchange trade. For example, it is possible to convert a long call position into a long put position or a short put into a short call.
UNDERSTANDING RISK REVERSALS
In theory, puts and out-of-the-money calls with the same exercise probability (delta) would trade at the same volatility price. If the trader is selling the out-of-the-money dollar call, the trader will want to earn 1.0%.
IMPLICATIONS FOR TRADERS
As a result, out-of-the-money calls may trade at a higher volatility price than out-of-the-money puts, or vice versa. This implies that out-of-the-money puts and calls would trade with similar volatilities.
IMPLICATIONS FOR HEDGERS
If the market has no strong view, the level of the risk reversal tends to zero. When the options market starts to believe in a lower dollar, out-of-the-money puts will start trading over out-of-the-money dollar calls.
CONCLUDING REMARKS
A hedger would therefore benefit from a larger risk reversal spread of dollar calls above puts. The hedger would therefore benefit from the greater risk spread of dollar puts over calls.
OPTION PRICE
WHAT RATE TO USE?
LIVE PRICE
PRICING TERMS
PREMIUM CONVERSIONS
SETTLEMENT
This means that only the profit on the option of the writer is paid to the holder of the option. If decided at the time of exercise, the writer will usually give the holder a spot foreign exchange rate and if this rate is acceptable, the option profit will be determined accordingly.
HOW IS AN OPTION EXERCISED?
If a net settlement is agreed upon at the time of the original trade, a more formal arrangement may be required to determine the profit per option at the time of exercise.
RISKS
There is a transaction-related risk if leveraged, similar to the risk of a spot settlement, which requires a line of credit to be in place prior to the transaction.
CONCLUDING REMARKS
Fair value usually refers to the value of an option premium according to a mathematical model. In-the-money Describes an option whose strike price is more advantageous than the current market price of the underlying.
LONG OPTIONS
SHORT OPTIONS
The following are examples of the first generation of currency options and today are classified as "vanilla" or standard options. It should be noted that if there is no delta protection and the position is held to maturity, then a short option position is no more risky than a full forward position.
STRADDLE
Straddles are bought when there is an expectation of a large move in the spot rate, but there is uncertainty about the direction of that move. On the other hand, straddles are sold when there is expected to be little movement in the spot foreign exchange market and there is a desire to receive premiums.
STRANGLE
Strangles are sold when there is an expectation for a trading range and a desire to receive two premiums. Obviously, there is more risk involved in selling strangles because the maximum loss is unlimited.
CYLINDER
Traders would buy puts if the exchange rate is expected to break outside of its trading range, but there is a certain amount of uncertainty about the direction, plus there is no reluctance to pay two premiums. It should be noted that a cylinder is often built so that there is no net premium to pay.
COLLAR
If the spot exchange rate at maturity is less than $/sfr 1.5400, the dollar put is exercised and the dollars would have been purchased at $/sfr 1.5400. If at maturity the spot exchange rate is higher than $/sfr 1.5600, the dollar call option is exercised and the dollars would have been purchased at $/sfr 1.5600.
PARTICIPATING FORWARD
This strategy is used when there is a desire to reduce the premium paid and the position needs to be hedged and there is a willingness to give up some participation in the profit for the benefit of being fully hedged. Usually, a participating forward is built in such a way that there is no net premium to pay.
RATIO FORWARD
There is also a belief that there will not be much movement against the existing underlying position. It should be noted that a ratio forward is usually constructed so that there is no net premium to be paid.
ADDED EXTRAS TO VANILLA OPTIONS
The remaining $2.5 million will then be purchased at the current foreign exchange rate. In effect, enabling the hedger to take advantage of favorable foreign exchange movements beyond the cap/floor level of a vanilla collar option, as long as a specified cap rate is not reached at any point during the life of the option.
DIRECTIONAL OPTIONS
This is a good position to have if a trader wants to be in the market but is unsure about the bullish expectations. This is a good position to have if a trader wants to be in the market but is unsure about the bearish expectations.
PRECISION OPTIONS
If the market is at B, the profit from the option's decline accelerates fastest over time. If the market is at A, the profit from the option's decline accelerates the fastest over time.
LOCKED TRADE OPTIONS
However, in general, the growth of the exotic options market over the last few years has shown firstly how the technical side of the market has progressed and secondly how the sophistication of the customer has also developed. Almost every day major market players are developing new exotic options, with exotic sounding labels; however, the most popular classified exotics are mentioned below.
BARRIERS
A default option that is automatically canceled if spot trades occur through one of the two predetermined knockout levels. The knockout level is below the initial spot for a call option and above the spot for a put.
AVERAGE RATES
At the end of the 12-month period, the average rate is calculated from 12 individual determinations. However, if the average interest rate is above the exceptional rate, the company will receive compensation for the difference between the average interest rate and the exceptional rate.
LOOKBACK AND LADDERS
In addition, a call option with an optimal interest rate gives the option buyer a payout equal to the difference between the option's strike and the highest spot rate over the life of the option. The payout on the option is equal to the difference between the spot dollar/yen exchange rate at the option's expiration (the rate at which the company will actually buy dollars) and the lowest dollar/yen rate traded during the life of the option.
CHOOSER
Obviously, the more steps that are added, the more the price of the option will approach the price of a lookback. The benefit of the option is largely dependent on the option buyer's ability on the option date to correctly identify which leg of the corresponding straddle will be in the money at expiration.
DIGITAL (BINARY)
Then, if the option is out of the money at expiration, the option expires worthless and the option holder receives no payout. Digital options also provide the same payout regardless of how far in the money the option is at expiration.
BASKETS
Identification of the currencies involved and their propensity to move in the same direction is critical to pricing the basket option. What's more, if the composition of the portfolio changes, the basket option can be shifted to reflect the new weights.
COMPOUND
Expiration nine months from compound expiration Strike price is at-the-money forward Premium price is 751 Swiss franc pips For comparison: European-style option. However, the total price of the compound option would be 1010 franc pips compared to 852 franc pips for the European style option.
VARIABLE NOTIONAL
The composite strike is 751 Swiss franc pips. The premium cost is 259 Swiss Franc pips. Details of the underlying option: Dollar put/Swiss franc call. The composite option therefore offers the buyer more flexibility in determining the timing of the hedge and reduces the upfront premium costs. In return, the total cost is higher (or the premium receipt is smaller for a compound put option).
MULTI-FACTOR
These products are combinations of vanilla and exotic options, and use "building blocks" to create payouts to suit specific needs and views of the market, from both buyers and sellers. Some of the most commonly used structures are listed below and it should be noted that these option structures are actually synthetic structures.
TRIGGER FORWARD
DOUBLE TRIGGER FORWARD
AT MATURITY TRIGGER FORWARD
FORWARD EXTRA
To hedge this exposure, the British company could sell the full three-month sterling forward at 1.5475 gbp/$ or buy a three-month sterling/dollar call with a strike rate of 1.500. Alternatively, a three-month forward extension with a strike rate of 1.5200 would leave the opportunity to sell sterling at the market foreign exchange rate up to a maximum of gbp/$1.6580 (the trigger rate), for as long as that 1.6580 gbp/$. not be traded at any time during the life of the option contract.
WEEKLY RESET FORWARD
1.5000 Also, assume in the foreign exchange market, the current foreign exchange rate is 1.5500 gbp/$, with the full three-month foreign exchange rate being gbp/$. Please note that the number of weeks that the fixed exchange rate is below $1.6900/sfr determines the size of the trade (x/52 of the total amount) to buy dollars against Swiss francs for the value two business days after the final expiration date . .
RANGE BINARY
The structure provides an opportunity to trade at a rate significantly better than the outright forward foreign exchange rate, but only for the portion of the amount that sets the foreign exchange spot rate above/below the trigger level. It should be remembered that if the trigger level weakens, that portion of the exposure would not be hedged.
CONTINGENT PREMIUM
No upfront premium is paid, but if the FX spot rate at expiration is above $1.6300/sfr, the buyer is liable to pay $6.88%, versus a European strike $1.6300 Swiss franc call/put cost of 2.75% . dollars. So the worst possible scenario is that the spot forex at expiration is just above $1.6300/sfr, so a higher premium must be paid for an option that is only slightly in the money.
WALL
This option structure represents a potentially cost-free strategy if the spot price is below $/sfr 1.6300, in which case the underlying asset is in-the-money.
CORRIDOR
This particular product can be used on its own as a currency play for a buyer looking at the direction of the market, or with corridor and range binary options combined with a deposit for a potential yield-enhancing structure. In all examples, figures and assumptions have been provided to help illustrate how the examples can be applied and do not relate to actual market rates.
HEDGING
However, if any of the premium trigger levels trade at any time before expiration, the hedger will have to pay 235.5 franc pips at each level. If none of the trigger levels trade at any time before expiration, the currency option will be purchased at no cost.
TRADING
The premium cost is 1.30% of the dollar or 204 franc pips (the European comparable option cost would be 1.83% of the dollar).
INVESTMENT
Here, once again, a portion of the interest that would be earned on the deposit is used to pay for the purchase of the option. Once again, a portion of the interest that would be earned on the deposit is used to pay for the purchase of the option, therefore:.
BID TO OFFER EXPOSURE
In-the-money option Out-of-the-money option Contract awarded Foreign currency Foreign currency. Compound option Compound option in-the-money out-of-the-money Contract awarded Foreign currency Foreign currency.
CONCLUDING REMARKS
Selling more out-of-the-money currency options funds the purchase of an in-the-money currency option. Conversely, selling less of an in-the-money option funds out-of-the-money currency options.
