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20 Options
20 Options
20 Options
By Soeren Hansen
What is an Option?
A Currency Option is an option, but not an obligation to buy or sell currency during a specified time period (time to maturity, T) at a specified price (exercise/strike price, X) The price or value of the option is called the premium, P Two different Options:
1. 2.
A currency Call option is an option but not an obligation to buy currency during a specified time period at a specified price A currency Put option is an option but not an obligation to sell currency during a specified time period at a specified price
An European currency option is an option, which can be exercised only on the maturity date An American currency option is an option which can be exercised any time prior to the maturity date
Why an Option?
Since the the holder of a Currency Option has the right but not the obligation to trade currency, it is beneficial to use options to hedge potential transactions (ex. bids not yet accepted) The exercise/strike price and the premium together determine the the floor or ceiling established for the potential transaction
Call Option
The Call Option establishes a ceiling for the exchange rate, and the option can be used to hedge foreign currency outflows (potential payments) If S>X => Profit increases one-for-one with appreciation of the foreign one-forcurrency. At (X+P) the holder of the option breaks even (ceiling price) If S<X => The call option will not be exercised, because the holder is better off buying the foreign currency in the spot market. The holder will have a negative profit reflecting the premium, P
S X -P X+P
Put Option
The Put Option establishes a floor for the exchange rate, and the option can be used to hedge foreign currency inflows If S>X => The call option will not be exercised, because the holder is better off selling the foreign currency in the spot market. The holder will have a negative profit reflecting the premium, P If S<X => Profit increases one-for-one with depreciation of the foreign one-forcurrency. At (X-P) the holder of the option breaks even (floor (Xprice)
S X-P -P X
Option Pricing
For European options Black-Scholes pricing model Black Garman & Kohlhagen For both European and American option: Binomial pricing model Implicit finite difference method
I will not go into these different pricing models, but for the interested student see John C. Hull Options, Futures and other Options, derivatives derivatives
The value of an option on its maturity date is either its immediate exercise value or zero, whichever is higher If two options are identical in all respects with the exception of the exercise price, a call option with a higher exercise price will always have a lower value and a put option with a higher exercise price will always have a greater value than the corresponding options with lower exercise prices
If two American options are identical in all respects with exception of the length of the contract, the longer contract will have a greater value at all times (more flexible) Prior to expiration, an American option has a value at least as large as the corresponding European option (more flexible)
A larger (positive) difference between the domestic and foreign interest rate (i i*), increases the price of a call and decreases the price of a put (expected appreciation of the home currency) The value of the option increases as the volatility of the underlying currency increases
Example
B.Lack & S.Choles Enterprises of Salem, OR imports French wine. The wine is really rare, so B.Lack & S.Choles have to bid for the wine. On November 2nd B.Lack & S.Choles bids 62,500, but the firm will not know until December 15th whether the bid is accepted or not. Recently the dollar tanked against the euro, so to protect against a further appreciation of the euro, the firm purchases a 62,500 call option. The strike price is 1.2750 $/ and the option premium is one cent pr. euro. The $/ ceiling price is therefore 1.2850 $/, for a maximum $/ payment of $80,312.5
Example
If the euro appreciates to 1.3000 $/, the payment $/ without the option would be $81,250, so B.Lack & S.Choles will exercise the option and purchase the euro for 1.2750, which is a payment of $79,687.5 + premium of $625 If the euro depreciates to 1.2000, B.Lack & S.Choles will be better of buying euro on the spot market, so they let the option expire unused. The payment is then $75,000 + premium of $625
Questions?
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