Jones Graduate School Masa Watanabe

Rice University

INTERNATIONAL FINANCE

MGMT 657

CURRENCY OPTIONS AND OPTIONS MARKETS

Currency Options ............................................................................................ 2

Option Hedge .................................................................................................. 6
Option Profit Calculation................................................................................ 7
Currency Option Sensitivities......................................................................... 9
Put-Call Parity............................................................................................... 10
Option Delta and Delta Hedge...................................................................... 11
Practice Problems with Solutions ................................................................. 13

Call Put (CME hand signals)

There are two times in a man’s life when he should not

speculate: when he can’t afford it and when he can.
Mark Twain
International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

CURRENCY OPTIONS
¾ A European call option is the right to buy the underlying currency at a specified
price (strike price) on a specified date in future (expiration date).
¾ A European put option is the right to sell the underlying currency at a specified
price (strike price) on a specified date in future (expiration date).

Notation
Today is date t, the maturity of the option is on a future date T.
Std/f : Spot rate on date t, value of currency f in currency d.
Kd/f : Strike price
id : Interest rate on currency d
if : Interest rate on currency f
σ : Volatility of the spot rate
C : Price of a call option
P : Price of a put option

¾ An option is a right and not an obligation, so the payoff to its holder is never
negative.
¾ At maturity, the holder of a European call option exercises the option and receives
the foreign currency (worth $STd/f, the spot rate at maturity) in exchange for the strike
price, $Kd/f, only if STd/f > Kd/f.

PayoffT$/€ Payoff at maturity of a euro call

option with strike price $1.12/€

At-the-money

Out-of-the-money In-the-money

$0.25/€

$/€ ST$/€
K =
$1.12/€ $1.37/€
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International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

¾ The holder of a European put option exercises the option and sells one unit of the
foreign currency (worth $STd/f) for $Kd/f only if STd/f < Kd/f.

PayoffT$/€ Payoff at maturity of a euro put

option with strike price $1.12/€

At-the-money

In-the-money Out-of-the-money

$0.25/€

$/€ ST$/€
$0.87/€ K =
$1.12/€

¾ A European option is exercisable only at expiration.

¾ An American option is exercisable any time until expiration.
¾ An option is too good to be free—unlike a forward or futures contract, an option has a
premium (price) to be paid upon purchase.
¾ Note: A forward “price” or a futures “price” is a contractual number and not the
value of the forward or futures contract (which is zero at inception—no money
changes hand). An option has a positive value at inception (and at any time in its
life).

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 International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

WSJ Options Indication (WSJ online 10/30/2007, retrieved in the evening)

Exchange Maturity

Contract size

Note: The underlying assets for CME currency options are CME futures contracts.

CME GBP December 2000 call (American)

Type of option : a call option to buy GBP
Underlying asset : CME December GBP futures contract
Contract size : £62,500
Expiration date : 3rd week of December
Exercise price : US$2.000/£
Rule for exercise : an American option exercisable anytime until expiration
Premium : ¢6.83/£, or £62,500 × .0683US$/£ = US$4,268.75 / contract
Note: In August 2005, CME began trading European-style currency options also.
¾ Most popular strike prices are those around the forward rates.
¾ When the strike price of an option is equal to the forward rate, these options are said
to be forward at-the-money (forward ATM). Forward ATM options are most liquid
options.

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 International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

™ For a profit-and-loss analysis (as opposed to a payoff analysis), don’t forget to

subtract the premium (cost). Suppose there are 90 days until the expiration of a
European euro call option and the three month $ interest rate (say LIBOR) is 1.2%. If
the option premium is ¢2.14/€, its future value is

¢2.14/€ × (1 + 0.012×90/360) = ¢2.146

This cost should be subtracted from the payoff (see below).

™ Q2. Why do we compute FV?

ProfitT$/€ Profit of the euro call option

with strike price $1.12/€

At-the-money

Out-of-the-money In-the-money

$0.22854/€
= 1.37 – Strike – FV(Premium)
BE
$1.14146/€ ST$/€
FV(Premium)
$1.37/€
-$0.02146/€
K$/€ =
$1.12/€

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 International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

OPTION HEDGE

™ Example. Again consider a U.S. distributor who imports wine from France. Its
position can be hedged by buying € call options.

Import Liability Call option

$/€ $/€
ProfitT ProfitT

ST$/€
+
K$/€
ST$/€
-FVPrem

Hedged position
$/€
ProfitT

K$/€

= -FVPrem

ST$/€

-K$/€ -FVPrem

¾ The cost at expiration is at most the strike price plus the future value of the premium.
If the distributor can sell the wine at a higher price, it can secure a profit.

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 International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

OPTION PROFIT CALCULATION

Consider an exporter to Germany who has a €1 million account receivable due in 6

months. Suppose they hedge their exposure by buying the following put option for full
coverage:

Export Put option

Account Receivable : €1 million Strike : $1.25/€
A/R due : 6 months Premium : ¢4.0/€
US$ interest rate : 2% Time to maturity : 6 months

Export Long Put Hedged

Profit$ Profit$ Profit$

1.2096
+ 1.2096 =
Slope 1
1.25 ST$/€
ST$/€ -0.0404 1.25 ST$/€

™ Suppose the spot rate at maturity turns out to be $1.20/€. The put option is in the
money. Î Exercise the option.
¾ The payoff from the hedged position is $1.25/€.
¾ The future value of the premium is
0.04×(1+.02/2) = 0.0404$/€.
The profit of the hedged position is
1.25 – 0.0404 = 1.2096$/€.
¾ The total profit is 1.2096 $/€ × €1M = $1.2096M.
™ If the terminal spot rate is $1.30/€, the put option is out of the money. Î Do not
exercise.
¾ The payoff from the hedged position is $1.30/€.
¾ The profit of the hedged position is
1.30 – 0.0404 = 1.2596$/€.
¾ The total profit is 1.2596 $/€ × €1M = $1.2596M.

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International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

Option value = Intrinsic value + Time value

Intrinsic value = Value if exercised immediately
Time value can be considered the value of insurance.

Call value

High volatility

Low volatility

Time value
Intrinsic value

Spot rate
¾ The higher the volatility, the higher the option value. Intuitively, the insurance
provided by the option is more valuable:

Currency call
option value

Call option value

Time value

Intrinsic value

Exchange rate

Exchange rate distribution

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International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

CURRENCY OPTION SENSITIVITIES

(For American options)

Call Put
Spot FX rate ↑ ↓
Strike price ↓ ↑
Domestic interest rate ↑ ↓
Foreign interest rate ↓ ↑
Volatility ↑ ↑
Time to expiration ↑ ↑

™ Q3. Why does a call option price increase with the domestic interest rate and
decrease with the foreign one? (Effects of other variables should be intuitive.)

™ Q4. Of these six variables, which is unobservable? How do you measure it?

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International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

PUT-CALL PARITY
¾ What happens if you buy a call option and sell short a put option with the same strike
price?

Long Call Short Put

CallT$/ -

ST$/£ + ST$/£

Long Spot Bond

ST$/ K$/£

= −
$/£
ST$/£
K
$/£
ST
¾ This is an arbitrage condition that holds strictly in a liquid currency market.

Put-Call Parity at Maturity (at T)

CTd/f - PTd/f = STd/f - Kd/f

where C and P are the prices of a call and a put option, respectively, with the same
strike price Kd/f.

¾ More generally at time t,

European Put-Call Parity (at t)
,T − K
Ft d/f d/f
d/f d/f S td/f K d/f
Ct – Pt = − =
1 + if 1 + id 1 + id

where id and if are the interest rates (prorated, as usual) on currencies d and f,
respectively.

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International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

OPTION DELTA AND DELTA HEDGE

¾ Option delta is the sensitivity of the option value to changes in the value of the
underlying currency.

™ Q5. In the previous picture, what represents the option delta?

™ Q6. Option delta is positive for a call, and negative for a put. Why?

™ Q7. Option delta is between 0 and 1 for a call, and between -1 and 0 for a put.
Why?

™ This means the following: suppose the delta of a € call option is 0.50.
¾ Delta-hedge the option by a spot contract : you would short €0.50 spot.
¾ Delta-hedge the option by a futures contract: you would short about €0.50 worth
of the futures contract (because the delta of a futures contract is close to 1).
¾ Conversely, if you want to delta-hedge your long €1 transaction (say your export
position) by the call option, you would short €2 of the call option.

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International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

Suggested solution to questions

Q1. The first three columns represent call option prices (premiums), because they
decrease with strike price. The others are puts.
Q2. We should compute the future value because the payoff of an European option
occurs at maturity.
Q3. We will make only an intuitive argument. Buying and selling the foreign currency at
the forward rate is a “fair” deal in that C = P for options with K = F (see the
European Put-Call Parity). If the domestic interest rate rises or the foreign interest
rate declines, F will rise by the IRP (K < F), and this makes a call (put) option
buying (selling) at K more (less) valuable, i.e., C ↑ (P ↓), and vice versa.
Q4. The spot rate volatility is unobservalble. You can measure it, either by historical
time series of the spot FX rate (called historical volatility) or by backing out the
volatility from prices of traded options using the Black-Scholes formula (implied
volatility).
Q5. Graphically, option delta is the slope of the option value diagram. Mathematically,
this is the first derivative of option price with respect to the spot rate.
Q6. Option delta is positive for a call, because the call option price increases with the
spot rate. It is negative for a put for the opposite reason.
Q7. Graphically, the slope of the call option value approaches to 0 as the spot rate
decreases (OTM). It will converge to the 45 degree line as the spot rate tends to
infinity (ITM). Contrarily, the slope of the put option value approaches to -1 when
the spot rate decreases (ITM), and to 0 when the spot rate becomes very high
(OTM).

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International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

PRACTICE PROBLEMS WITH SOLUTIONS

Solve the following end-of-chapter problems from Butler:
6.5 a
7.4, 7.5

Solutions

6.5 a. The optimal hedge ratio for this delta-hedge is given by:
NFut* = (amt in futures)/(amt exposed) = -β
⇒ (amt in futures) = (-β)(amt exposed) = (-1.025)(-DKr10bn) = DKr10.25bn.
So buy DKr 10.25bn, which is equivalent with selling
(DKr10.25bn)($0.80/DKr)/($50,000/contract) = 164,000 contracts of the dollar futures.

7.4 The arguments are the same as for call options. As the variability of end-of-period spot rates
becomes more dispersed, the probability of the spot rate closing below the exercise price increases
and put options gain value. Here are the three sets of graphs:

Spot exchange rate volatility and

at-of-the-money put option value

Sd/f Sd/f
0

3
-2

-1

-2

-1

-3 -3

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International Finance Fall Term II, 2007
CURRENCY OPTIONS AND OPTIONS MARKETS

Spot exchange rate volatility and

out-of-the-money put option value

Sd/f Sd/f

-2

-1

-2

-1

3
-3 -3

Spot exchange rate volatility and

in-the-money put option value

Sd/f Sd/f
-2

-1

-2

-1

3
-3 -3

Increasing variability in the distribution of end-of-period spot rates results in an increase in put
option value in each case. (For in-the-money puts, the increase in option value with decreases in the
underlying spot rate is greater than the decrease in value from proportional increases in the spot
rate.) Variability in the distribution of end-of-period spot exchange rates comes from exchange rate
volatility and from time to expiration.

7.5 Buy an A$ call and sell an A$ put, each with an exercise price of F1$/A$ = $0.75/A$ and the same
expiration date as the forward contract. Payoffs at expiration look like this:

Long Call Short Put Synthetic Forward

Payoff Payoff Payoff

0.75 ST$/A$ ST$/A$

0.75 ST$/A$ + = 0.75

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