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FX Options

FX Options. Traded. FX Options. Definition An option is the right but not the obligation to buy (call) or sell (put) a currency at an agreed rate (strike price or exercise price) over a certain period of time. For this right a premium is paid (usually at the start).

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FX Options

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  1. FX Options Traded

  2. FX Options Definition An option is the right but not the obligation to buy (call) or sell (put) a currency at an agreed rate (strike price or exercise price) over a certain period of time. For this right a premium is paid (usually at the start).

  3. FX Options Terminology • American, the option may be exercised (or not) at any time in the option period • European, the option may be exercised (or not) only at expiry • OTC, over the counter or bespoke options • Traded, where options are traded on an exchange and therefore the contracts have to be precisely specified

  4. FX Options The Specification • Contract size • Premium • Expiry date

  5. FX Options • In, At and Out of the Money • GBP call i.e. (call for GBP give USD) SP 1.43 Current Spot 1.45 1.43 1.41 Option is In At Out of the money

  6. FX Options • Dec call, SP 1.46, premium 1 cent • 2 cents • 1 cent • 1.43 1.44 1.45 1.46 1.47 1.48 Rate at expiry 0 - 1 cent - 2 cents Value in cents

  7. FX Options • Which cash price is the underlying? • September GBP call with SP 165 • Today is June 20th • Current spot is 1.6930 • 3 Mo fwd is 1.6785 • You have two alternatives. Exercise today or sell sterling forward, Which action will give you most profit as it is against this that the seller will base the price? • 1) Exercise today Give USD1.6500 Get GBP 1 • Get USD 1.6930 Give GBP 1 • Net 430 • Or Sell GBP forward at expiry day and exercise on expiry • Give USD 1.6500 Get GBP 1 • Get USD 1.6785 Give GBP 1 • Net 285 • So underlying is spot

  8. FX Options • Ref the underlying • Note GBP is at a discount to the dollar therefore is ‘strongest’ at spot so Call = spot is underlying Put = forward is underlying For currencies at a premium to the USD, then vice versa

  9. FX Options • Effective rate • Suppose we decide to buy a GBP call i.e. will give USD to get GBP • Then if the SP is 1.65 and the premium is 1 cent the effective rate if we exercise will be • 1.65 • +.01 • 1.66 • If this had been a put but using same SP and premium, then the effective rate would be • 1.65 • -.01 • 1.64 • Note that the premium is always a cost therefore for the call we pay more USD and for the put we receive less USD

  10. FX OptionsBetter to sell than to Exercise Today is July 23rd • We have a September GBP call, SP 165 • Today’s spot rate is 1.6930 • And the current premium for the option in the market is 5.62 cents • We need the GBP today • We could exercise in which case the cost would be (ignoring the sunk cost of the premium paid) - 1.6500 • Or we could sell and receive 5.62 cents = + .0562 • We would need to buy GBP spot - 1.6930 • Net cost - 1.6368

  11. FX Options • Intrinsic and Time Value • GBP Call at 1.8250 for September • Current Spot 1.8840 • 5.90 cents: Intrinsic Value • Premium 6.05 • .15 Time Value

  12. FX OptionsTime Value • x Value at expiry x Out of the money At the money In the money

  13. FX OptionsTime Value

  14. FX OptionsTime value Value Today Expiry Time to Expiry

  15. FX OptionsPay offs for USD I,000,000 • 725 • 720 • 715 GBP 710 000’s 705 • 700 Forward 1.4286 • 690 • 1.39 1.40 1.41 1.42 1.43 1.44 1.45 1.46 1.47 1.48 1.49 1.50 1.51 1.52 1.53 • 685 • 680 Option SP144 • 675 • 670 Leave open

  16. FX OptionsStrategy • Decide whether to use options or not versus leave open or cover. Issues:- cost, policy, view of fx movements If yes then, • Puts or calls? • How many contracts? • Expiry Date, sometime beyond exposure date but how far? • Strike price?

  17. FX OptionsStrategy If yes then, • Puts or calls? Well what is the exposure? • Assuming traded options to be used -How many contracts? 3. Expiry Date? - Sometime beyond exposure date but how far? - Cost of time, versus decay, versus view of volatility

  18. FX OptionsStrategy • Strike price? - In, At or Out of the money - Need to know ‘underlying’ - Premium

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