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Chapter 7 - Currency Option
Chapter 7 - Currency Option
Chapter 7 - Currency Option
SEVEN
FOREIGN CURRENCY
OPTIONS
1
CHAPTER OVERVIEW
• Introduction
• Contract specifications
• Option positions
• Hedging using option contract
• Strategy on currencies option
• Option pricing
2
FOREIGN CURRENCY OPTIONS
3
FOREIGN CURRENCY OPTIONS MARKETS
▪ Table shows option prices on British pound taken from the online edition of
Wall Street Journal on Friday, January 31, 2007
4
12-Jan-24 5
FOREIGN CURRENCY OPTIONS
6
FOREIGN CURRENCY OPTIONS
7
FOREIGN CURRENCY OPTIONS MARKETS
8
OPTION POSITIONS
There are four types of options positions: #
• A long position in a call option
• A long position in a put option
• A short position in a call option
• A short position in a put option
The underlying assets
• Commodities
• Stock
• Foreign currency
• Index
• Futures…
9
PROFIT & LOSS FOR THE BUYER OF A CALL OPTION
+5
Unlimited profit
0 Spot price
160 165 170 175 180 (US cents/£)
Limited loss
-5
Break-even price
- 10
Loss
The buyer of a call option on £, with a strike price of 170 cents/£, has a limited loss of 5 cents/£ at spot
rates less than 170 (“out of the money”), and an unlimited profit potential at spot rates above 170
cents/£ (“in the money”). 10
PROFIT & LOSS FOR THE WRITER OF A CALL OPTION
Profit
(US cents/£) Strike price
+ 10
+5 Break-even price
Limited profit
0 Spot price
160 165 170 175 180 (US cents/£)
-5 Unlimited loss
- 10
Loss
The writer of a call option on £, with a strike price of 170cents/£, has a limited profit of 5 cents/£ at
spot rates less than 170, and an unlimited loss potential at spot rates above (to the right of) 175
cents/SF. 11
PROFIT & LOSS FOR THE BUYER OF A PUT OPTION
+5 Profit up
To 165
0 Spot price
160 165 170 175 180 (US cents/£)
Limited loss
-5
Break-even
price
- 10
Loss
The buyer of a put option on £, with a strike price of 170cents/£, has a limited loss of
5 cents/£ at spot rates greater than 170 (“out of the money”), and a profit
potential at spot rates less than 170cents/£ (“in the money”) up to 165 cents. 12
PROFIT & LOSS FOR THE WRITER OF A PUT
OPTION
Profit
(US cents/£) Strike price
+ 10
Break-even
+5 price
Limited profit
0 Spot price
160 165 170 175 180 (US cents/£)
-5
Loss up
- 10 To 165
Loss
The writer of a put option on £, with a strike price of 170 cents/£ has a limited profit of
5 cents/£ at spot rates greater than 165 and a loss potential at spot rates
less than 165 cents/£.
13
12-Jan-24 14
OPTION POSITIONS
There are four types of options positions: #
• A long position in a call option: MUA QUYỀN CHỌN MUA: ĐẦU TƯ
GIÁ TĂNG MẠNH: thực hiện khi S(t)>E, không thực hiện khi S(t)<E
• A long position in a put option: MUA QUYỀN CHỌN BÁN: ĐẦU TƯ
GIÁ GIẢM MẠNH: thực hiện khi S(t)<E, không thực hiện khi S(t)>E
• A short position in a call option: BÁN QUYỀN CHỌN MUA: ĐẦU
TƯ GIÁ GIẢM NHẸ HOẶC KHÔNG TĂNG KHÔNG GIẢM
QUANH VÙNG GIÁ THỰC HIỆN:thực hiện khi S(t)>E, không thực
hiện khi S(t)<E
• A short position in a put option: BÁN QUYỀN CHỌN BÁN: ĐẦU TƯ
GIÁ TĂNG NHẸ HOẶC KHÔNG TĂNG KHÔNG GIẢM QUANH
VÙNG GIÁ THỰC HIỆN: thực hiện khi S(t)<E, không thực hiện khi
S(t)>E
15
STRATEGIES INVOLVING A SINGLE
OPTION AND A STOCK
Profit
◼ Profit patterns.
◼ (a) Long position in a
stock combined with
short position in a call, x
x
ST ST
◼ (b) Short position in a
stock combined with
long position in a call.
(a) (b)
◼ (c) Long position in a
Profit Profit
put combined with
long position in a
stock,
◼ (d) Short position in a x
x
put combined with ST ST
stock position in a
stock
(c) (d)
16
B1. BULL SPREAD CREATED USING CALL OPTION-
Buying a call on a stock with a certain price and selling a call on the same stock with a higher
price
X1 X2 ST
17
B1. BULL SPREAD CREATED USING CALL OPTION-
Buying a call on a stock with a certain price and selling a call on the same stock with a higher
price
X1 X2 ST
18
B2. BULL SPREAD CREATED USING PUT OPTION Buying a
put on a stock with a certain price and selling a put on the same stock with a higher price
Profit
X1 X2 ST
19
B3. BEAR SPREAD CREATED USING CALL OPTION
Buying a call AT a strike price and selling a call with a LOWER strike price
X1 X2 ST
20
B4. BEAR SPREAD CREATED USING PUT OPTION-
Buying a put at a strike price and selling a put with a lower strike price
Profit
X1 X2 ST
21
B5. BUTTERFLY SPREAD CREATED USING CALL
OPTIONS- Buying one call at low price X1 and buying another call at high strike price X3
and selling two call with a strike price X2, halfway between X1 & X3
Profit
This strategy refer to
an investment who
fells that large stock
price moves are
unlikely
X1 X2 X3
ST
22
BASIC OPTION PRICING RELATIONSHIPS AT EXPIRY
Profit
ST
–
(1 + i£)
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 7-25
EUROPEAN OPTION PRICING RELATIONSHIPS
▪ When the option is in-the-money, both strategies have the same payoff.
▪ When the option is out-of-the-money, it has a higher payoff than the
borrowing and lending strategy.
▪ Thus,
ST E
Ce > Max – ,0
(1 + i£) (1 + i$)
▪ Using a similar portfolio to replicate the upside potential of a put, we can
show that:
E ST
Pe > Max – ,0
(1 + i$) (1 + i£)
where
F 1
ln T + σ 2T
d1 =
E 2
T
d 2 = d1 − T
c = premium on a European call
p = premium on a European put
S = spot exchange rate (domestic currency/foreign currency)
( r − r )T
F = continuous compounding Forward rate Ft = St e h f
E = exercise or strike price, T = time to maturity
rd = domestic interest rate, rf = foreign interest rate
σ = Volatility (standard deviation of percentage changes of the exchange rate)
OPTION PRICING AND VALUATION
e-rT = continuously compounding discount factor (e=2.71828182…)
(1+12%)1 = 1.12
(1 + 12% / 2) 2 = 1.1236
(1 + 12% /12)12 = 1.126825
(1 + 12% / 365)365 = 1.127446
e12%1 = 1.1274969
ln = natural logarithm operator
N(x) = cumulative distribution function for the standard normal
distribution, which is defined based on the probability density
function for the standard normal distribution, n(x), i.e.,
2
1 − x2
x
n(x)dx=
x
N(x) = e dx
- -
2
OPTION PRICING AND VALUATION
• The pricing of currency options depends on six
parameters:
– Current spot exchange rate ($1.7/£)
– Time to maturity (90 days)
– Strike price ($1.72/£)
– Domestic risk free interest rate (r$ = 8%)
– Foreign risk free interest rate (r£ = 7.8%)
– Volatility (10% per annum)
Based on the above parameters, the call option premium is
$0.0246/£(this result is calculated based on the Black-Scholes
formula in the excel file “GK” Garman Kohlhagen)
Inputs Outputs
Spot rate (DC/FC e.g. USD/EUR) 170 Call Price = 2.4666
Strike price 172
volatility (annualized) 10.00% Put Price = 4.3453
domestic interest rate (annualized) 8.00%
foreign interest rate (annualized) 7.80%
time to maturity in days 90
time to maturity in years 0.25
30
12-Jan-24 31
Exhibit: Intrinsic Value, Time Value & Total Value for a Call Option
on British Pounds with a Strike Price of $1.70/£
Option Premium
(US cents/£)
-- Valuation on first day of 90-day maturity --
6.0
5.67
Total value
5.0
4.0 4.00
3.30
3.0
2.0 1.67
Time value
1.0 Intrinsic
value
0.0
1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74
18.00
16.00
Total value
14.00
12.00
10.00
8.00
6.00
3.30
Intrinsic
4.00
value
2.00
Time value
0.00
157.25 159.80 162.35 164.90 167.45 170.00 172.55 175.10 177.65 180.20 182.75 185.30
1.00
0.90
0.80
0.70
Delta (N(d1)
0.60
0.50
0.40
0.30
0.20
0.10
0.00
d
• 15 to14 days
premium cent 1.37 − 1.32
theta = = = 0.05
time 15 − 14
• 5 to 4 days
premium cent 0.7929 − 0.7093
theta = = = 0.08
time 5−4
• The rapid deterioration of option value in the last days prior to
expriration day
Theta: Option Premium Time value Deterioration
※ The negative slope means the option value decreases with the time
approaching the expiration date
※ For the at-the-money options, the decay of option values
accelerates when the time approaches the expiration date
VEGA
• Sensitivity to volatility (Vega): #
– The vega for calls and puts are the same
c
Vega ν (for calls) =Se-rf T n(d1 ) T 0
σ
p
Vega ν (for puts) =Se-rf T n(d1 ) T 0
σ
– Volatility is important to option value because it measures the
exchange rate’s likelihood to move either into or out of the range in
which the option will be exercised
– The positive value of vega implies that both call and put values rise
(fall) with the increase (decrease) of σ
– The intuition for positive vega of both calls and puts is that since
the options give the holder the right to fix the purchasing or the
selling prices, options are more valuable in the scenario with higher
volatility
VEGA
• Volatility increase 1%, from 10% → 11%:
9.0
8.0
7.0
6.0
ITM call (K=$1.65/£)
5.0 ATM call (K=$1.70/£)
3.0
2.0
1.0
0.0
-0.06 -0.04 -0.02 0 0.02 0.04 0.06
rUS$ – r£
※ When the interest rate differential (rd – rf) increases, the foreign
currency call value indeed increases
RHO AND PHI
• Speculation strategy based on the expectation of the
domestic interest rate
– Because rd↑ c↑ and rd ↓ p↑, a trader should purchase a
call (put) option on foreign currency before the domestic
interest rate rises (declines). This timing will allow the trader
to purchase the option before its price increases
SUMMARY OF OPTION VALUE SENSITIVITY
Greek Definition Interpretation
Delta Δ Expected change in the option value The higher (lower) the delta, the more
for a small change in the spot rate likely the call (put) will move in-the-
money
Theta Θ Expected change in the option value For at-the-money options, premiums are
for a small change in time to relatively insensitive until the final 30
expiration days
Vega υ Expected change in the option value Option values rise with increases in
for a small change in volatility volatility both for calls and puts
Rho ρ Expected change in the option value Increases in domestic interest rates
for a small change in domestic cause increasing call values and
interest rate decreasing put values
Phi φ Expected change in the option value Increases in foreign interest rates cause
for a small change in foreign interest decreasing call values and increasing put
rate values