Currency Options

Options on foreign exchange? It's really no different to options on shares, real estate or
whatever. The basic premise is that the buyer of an option has the right but not the
obligation to enter into a contract with the seller. Naturally the option owner exercises
this right when it is to his/her advantage. Currency options specify a foreign exchange
contract and give the owner the right to enter into the specified contract during a preagreed period of time.
Currency Options have gained acceptance as invaluable tools in managing foreign
exchange risk. They are used extensively and make up between 5 - 10 % of total
turnover. Currency options bring a much wider range of hedging alternatives to portfolio
managers and corporate treasuries.
Currency options can be used to trade foreign exchange and to hedge foreign exchange
risks.
Trading & Speculation
Currency options offer some unique features to the speculator. Purchasing an option you
know that your downside is limited to the premium you invest. Sounds great and it is.
However you should also know that the probability of make a profit is depending on
where the option strike is. If US$/JPY spot is 120.00 and you buy a 1 month 140.00
strike US$ Call, the premium will be small but the probability of losing it all is very high.
On the other hand if you sell options you receive premium but you also are exposed to
unlimited loss if the market moves against your position.
Hedging With Options
Options offer some very interesting features for hedging. There are a wide variety of
different types of options to match the full spectrum of risks that companies and fund
managers inherit as part of their international trade and investment.
If it important that risk managers understand the products they are buying and exactly
how they perform under different scenarios. The goal being to negate the existing risks
of the business.
Intrinsic Value
An option is said to have intrinsic value where the strike price of the option is more
favourable than the current market forward rate.
As a general rule, the greater the intrinsic value of an option the higher its premium.

An option with some intrinsic value is described as being "in-the-money".

An option with no intrinsic value is said to be "out-of-the-money".
Where the strike price of the option is equal to the current forward rate the option
is said to be "at-the-money".

The premium of an option that has no intrinsic value is made up solely of time value.
Time value reflects the uncertainty of an option being exercised at expiry.
The time value of an option is a function of:

The relationship between the strike of the option and the current market forward
rate

The time period of the option

The interest rate differential
The expected volatility in the underlying currency-pair.

1. Relationship between strike and current market forward rate

The time value of an option will be at a maximum when the strike price of an option is
equal to the current forward rate. At that point, the degree of uncertainty surrounding
whether or not the option will be exercised will be at its highest level
As an option moves further "into the money" the time value of the option will fall as the
probability of it being exercised increases. Similarly, if the option moves further "out-ofthe-money" the time value of the option will also fall as the probability of it not being
exercised increases.
2. Time Period
In general, the longer the period of an option, the greater its potential pay-off and
therefore the more expensive it will be. While the amount of time value of an option will
increase as the maturity lengthens it will do so at a decreasing rate.
3. Interest Rate Differentials
The interest rate differential between the two currencies in any particular option affects
the option premium by affecting the relationship between the strike of the option and the
current market forward rate. Any movement in the interest rate differential that shifts the
underlying option further in-the-money will make the option more expensive; any
movement that shifts it further out-of-the-money will make it cheaper.
4. Volatility
The expected volatility in the underlying exchange rate is the most important variable in
pricing a currency option. The higher the volatility the greater the potential for large
exchange rate movements and hence the greater the potential pay-off of an option.
Consequently, higher volatility will translate into higher premiums for both puts and calls.
Option traders often differ in their expectations of future volatility. Influencing a traders
expectations will be the historical volatility of the particular currency pair (i.e. its recent
track record), the potential impact of future news and data releases on the currency, the
relative demand for options, other traders expectations and any other factors that the
trader feels could materially affect future movements in the currency.
Option Pricing
While it is not necessary to understand the actual mathematics of the option pricing
model, it is useful to have some understanding of how the various components of the
model affect the option premium.
The major inputs to models of this type are:
a.
b.
c.
d.
e.
f.

Current asset price

Exercise price
Time to expiry of option
Volatility
Risk-free money rate
Holding benefit or dividend rate on underlying instrument

The most famous option pricing theory work was done by Black and Scholes. Their work
has been subsequently modified for valuing options in a number of markets (e.g.
Garman-Kohlhagen for currencies, Black for futures, the Binomial model for American

options). The basic idea of these models is to specify the condition that a dynamic hedge
should be able to be created between an option and the underlying instrument, and then
to use the fact that the resulting riskless portfolio should earn the risk-free rate. The
solution to the equation specifying the condition, given the known boundary values of the
option at expiry provides the fair value of the option at any time and the hedging
mechanism required. It is assumed that the price of the underlying instrument follows
some sort of stochastic process.
In fact, it is now widely recognised that these models have reasonable validity in the case
of equities, currencies and commodities. The principal difficulties relate to the constant
volatility and constant interest rate assumptions, and are especially significant for longer
dated options. It is equally widely recognised that the models become increasingly shaky
for interest rate options, especially long--dated ones. Certainly, the problems
encountered for the other instruments are no less, but there is also a massive conceptual
problem in assuming a constant money rate for the life of the option while at the same
time using a stochastic process for the interest rate related instrument on which the
option is written.
It is important to realise that the fair value of an option calculated according to a Black
and Scholes type model only makes sense in the context of the riskless hedge argument.
It is certainly possible to buy options under fair value, as determined by you, and to lose
money; or to sell option above your fair value and lose money. The only way the fair
value can be locked in is by maintaining the dynamic hedge, either through the
underlying instrument itself or by means of other suitable options in a portfolio approach.
Even then, there is usually some degree of sensitivity to assumptions about the
underlying stochastic process and its volatility.
A good starting point from which to understand the pricing of a currency option is to
break the option premium down into two parts - its intrinsic value and its time value. For
any option, the premium will be equal to the sum of its intrinsic value and its time value.
Traders adopt a variety of strategies in managing the risks in their portfolios. Generally,
risk exposure is kept to an acceptable minimum by setting limits to losses given specified
degrees of adverse market movements.
Broadly, the profile of the risk exposure experienced is determined by the depth of the
trader's activity in the option market. e.g. broking (avoiding open positions) or spread
trading (limit loss potential) as opposed to market making. Risk is sensitive to the
trader's own perception of market movement. A trader will decide when to buy or sell
options (volatility positioning), when or how to hedge or when to close a position and
take profit/cut losses.
The only perfect hedge for any specific option is the same option on the other side.
However, such a strategy requires a large turnover and wide customer base to be
profitable. Most market makers do not hedge options on an "option-for-option" basis as
this is costly and is inefficient compared to a hedging strategy based on a portfolio
approach.
What is currency options delta ? The most obvious risk an option trader faces is the
movement in the underlying asset (spot exchange rates). The effect this has on an option
position depends on the direction and the extent of this movement. Generally, if the book
is long of options, any loss experienced is limited. However, if the book is short of
options, then losses are potentially unlimited.
Traders must therefore be aware of the sensitivity of the value of each option in their
book to movements in the spot exchange rate and this is reflected in the delta of the
option.

Delta = Change in option value / Change in underlying asset

A helpful interpretation of "Delta" is that it reflects the probability of exercise; although
this is not exactly true, as the delta of some exotic options can be significantly greater
than one. In the case of standard options, however, it is a useful interpretation.
The gamma effect means that position deltas move as the asset price moves and
predictions of revaluation profit and loss based on position deltas are therefore not
accurate, except for small moves.
Gamma (G) measures the response of an option's Delta to changes in rates.
Gamma = Change in Delta / Change in Underlying Asset
Bought options have positive gamma while sold options have negative gamma. A
portfolio's gamma will be the weighted sum of its option's gammas and the resulting
gamma will be determined by the dominant options in the portfolio. In this regard,
options close to the money with short time to expiry have a dominant influence on the
portfolio's gamma. The Gamma of an option increases as the option matures and
decreases with volatility.
A portfolio with a positive gamma gets longer as the market goes up and shorter as the
market goes down, which is ideal. A portfolio with negative gamma gets shorter as the
market goes up and longer as the market goes down.
A portfolio with a positive gamma is more attractive than a negative gamma portfolio
with time decay being the mitigating factor. A negative gamma means the rate of losses
increases as losses are sustained and the rate of profit falls as profits are experienced.
With delta neutral positions, the sign of Gamma is useful. If Gamma is negative, the
portfolio profits so long as the spot rate remains stable. If Gamma is positive, the
portfolio will only profit from large movements in spot rates in either direction.
To adjust the Gamma of a portfolio a trader must buy or sell additional option contracts
as the Gamma of a cash position is zero.
Risk reversals refer to the difference in pricing for a Put and a Call for a 25 Delta
option. Supply and demand in the options market often means that these Puts and Calls,
which theoretically should trade at the same volatility level, have differing prices.
The name 'Risk Reversal' comes from the fact that traders actually make markets in the
price difference between the 25 delta puts and calls. The affect of buying or selling the
risk reversal is to change the your risk to being:
Long Calls / Short Puts
or
Long Puts / Short Calls

Options Types
Whilst there appears to be an extraordinary and confusing array of currency options the
majority of them fall into just a few categories. From these basic building blocks more
complex and tailored structures are engineered to meet the hedging needs of end users.
Calls and Puts
Since in every currency transaction one currency is bought and another is sold the same
is true of options transactions. A Call option is the right to buy a currency and a Put
option is the right to sell. If you buy a Call option on one currency you are by definition
also buying a Put option on another. By definition each currency option is a Call and a Put
on the respective currencies as you cannot do one without the other.
Knock-Out Options
These are like standard options except that they extinguish or cease to exist if the
underlying market reaches a pre-determined level during the life of the option. The
knockout component generally makes them cheaper than a standard Call or Put.
Knock-in Options
These options are the reverse of knockout options because they don't come into
existence until the underlying market reaches a certain pre-determined level, at this time
a Call or Put option comes into life and takes on all the usual characteristics.
Average Rate Options
The options have their strikes determined by an averaging process, for example at the
end of every month. The profit or loss is determined by the difference between the
calculated strike and the underlying market at expiry.
Basket Options
A basket option has all the characteristics of a standard option, except that the strike
price is based on the weighted value of the component currencies, calculated in the
buyer's base currency. The buyer stipulates the maturity of the option, the foreign
currency amounts which make up the basket, and the strike price which is expressed in
units of the base currency.
Call/Put Options
Purpose
A Call option enables an option buyer to set a maximum price (rate) at which to buy a
currency against another currency. A Put option enables the buyer to set a minimum
price at which to sell a currency against another currency.
Description
A Call option is an agreement between the buyer and the seller of the option whereby the
buyer obtains the right but not the obligation to buy an agreed amount of a currency at a
pre agreed price (the strike price), on an agreed future date (the value date). The choice
of whether to use the option is made on the expiry date, which is 2 business days before
the value date. A Put option is in all respect the same except that it confers the right to
sell at a pre agreed rate. In return for the option, the buyer pays the seller a premium.
For the remainder of this example lets assume we are are referring to a bought NZ$
Call / US$ Put.
Settlement
Settlement only occurs if it is advantageous for the buyer to exercise the option. If the

NZ$ appreciates beyond the strike price, the buyer of an NZ$ Call option will exercise the
option and buy NZ$/sell US$ at the strike price. If the NZ$ is below the strike price at
expiry the buyer will simply let the option lapse.
Typical Uses
1. A customer wishing to gain protection against an appreciating (strengthening)
NZ$.
2. Customers who are involved in tenders which contain a foreign currency element
can protect themselves against adverse currency movements during the time
between lodging a tender and receiving notice of its outcome. Should the tender
be unsuccessful the maximum cost of hedging is limited to the amount of the
premium.
Example
Current Position
You are an Australian based exporter with a US$ 1,000,000 receipt due in three months
time. At that time you will need to purchase NZ$. The current three month forward rate
for NZ$/US$ is US$ 0.5000 (spot rate is also US$ 0.5000).
Market Outlook
You are unsure about the future direction of the NZ$ against the US$. You wish to protect
yourself against an NZ$ appreciation but would like to gain from any favourable rate
movement.
Suggested Solution
You purchase an NZ$ call option with a strike price of US$ 0.5000 for a total premium of
US$ 15,000. This equates to 1.50 % of the face value of the contract.
Result
If the NZ$/US$ exchange rate is above US$ 0.5000 you exercise the option. In this case
your elective exchange rate will be equal to the strike price plus the cost of the premium.
If the NZ$/US$ is below US$ 0.5000 you let the option lapse and buy NZ$ in the spot
market.
Knock Outs
Purpose
Knock-out options have been designed to provide customers with a high level of foreign
exchange protection at a lower cost than standard currency options, but without
removing a company's ability to profit from favourable currency movements.
Description
A knock-out option provides a customer with protection against adverse currency
movements in a similar way to a standard currency option. In addition to the normal
option variables, the buyer also selects a knock-out price which is a level at which the
option lapses and the buyer is left uncovered. If the knock-out price is reached before the
option matures the buyer must then choose between remaining uncovered, dealing in the
spot or forward markets or selecting new option protection. If the knock-out price is not
reached, the option is settled at expiry in the usual way.

Knockout levels are usually set such that the option lapses when it is out of-the-money,
i.e. when the spot price has moved in a direction favourable to the underlying exposure.
The appropriate rate may depend upon the customer's currency forecasts or may be
related to the relative premium cost of the option. The closer the knock-out level is to the
current spot rate the cheaper the option. Generally knock-out levels are set at a point
where the user will be happy to initiate spot/forward cover, or at a level just above/below
important resistance/support levels.
Typical Use

A company wishing to gain cost-effective protection against unfavourable currency

movements and who expects the spot rate will trend without significant correction

Exporter Example
Exposure
You are an New Zealand based exporter with US$ 10,000,000 in receipts due in three
months. At that time you will need to buy NZ$. The current spot price is US$ 0.5000. The
three month forward rate is US$ 0.5010.
Market View
You are unsure of the future direction of the New Zealand dollar against the US dollar.
You wish to protect yourself against an adverse currency movement but would like to
gain from a depreciation in the NZ$. You would be happy to deal in the spot market if the
spot price reaches 0.4700.
Possible Solution
You purchase a knockout NZ$ Call option with a US$ 0.5000 strike price and a US$
0.4700 knock-out price for a premium of US$ 150,000. This equates to 1.50% of the face
value of the contract. In comparison a standard three month NZ$ Call with a US$ 0.5300
strike price would cost significantly more at 1.80% or US$ 180,000.
Outcome
1. If the spot price of the NZ$ should trade at US$ 0.4700 (the knock-out rate) before
the option matures, the option automatically lapses leaving you without cover. At this
point you can deal in the spot market, cover in the forward market or select new option
protection.
2. If the NZ$/US$ exchange rate is above US$ 0.5000 and the option is not knocked-out
you will exercise the option. In this case your effective exchange will be equal to the
strike price less the premium.
3. If the NZ$ is between 0.5000 and 0.4700 you let the option lapse and buy NZ$ in the
spot market.
Knock In
Purpose
Knock-in options have been designed to provide customers with potentially more
attractive pay-off, when they are looking to sell options as part of a hedging strategy,
than they could generate by selling standard options.

Description
A knock-in option is an option that only comes into being when a pre-specified spot level
is reached. Once the option comes into existence it has all the characteristics of a
standard option and will be settled at expiry in the usual way i.e. if it is in-the-money it
will be exercised and if it is out-of-the-money it will lapse. If the knock-in level is not
reached before the option matures the option will not exist.
Typical Use

Knock-in options are generally used in conjunction will standard options to

construct cost-effective hedging strategies.

Exporter Example
Exposure
You are an New Zealand based exporter with a US$ 10,000,000 receipt due in six
months. At that time you will need to buy NZ$. The current spot price is US$ 0.5000 and
the six month forward price is US$ 0.5010.
Market View
You are unsure of the future direction of the New Zealand dollar against the US dollar but
you expect it to trade in a reasonably narrow range. You wish to protect yourself against
an adverse currency movement but would like to gain from a depreciation in the NZ$.
Possible Solution
You purchase a standard NZ$ call with a US$ 0.5000 strike price and sell a knock-in NZ$
put also with a strike price of US$ 0.5000 and a knock-in level of US$ 0.4700. This is a
zero cost strategy.
Outcome
1. If the NZ$/US$ exchange rate is below US$ 0.5000 at expiry, and during the life of the
option the market has traded at US$ 0.4700 so that the knock-in option has come into
being, then the bank would exercise its option and you would deal at US$ 0.5000.
2. If the NZ$/US$ exchange rate is above US$ 0.5000 you would exercise the NZ$ call
option.
3. If the NZ$/US$ exchange rate is below US$ 0.5000 at expiry, and has not traded at
US$ 0.4700 during the life of the option, then both options lapse and you deal at the
market rate.
Average Rate
Purpose
Knock-in options have been designed to provide customers with potentially more
attractive pay-off, when they are looking to sell options as part of a hedging strategy,
than they could generate by selling standard options.
Description
A knock-in option is an option that only comes into being when a pre-specified spot level
is reached. Once the option comes into existence it has all the characteristics of a

standard option and will be settled at expiry in the usual way i.e. if it is in-the-money it
will be exercised and if it is out-of-the-money it will lapse. If the knock-in level is not
reached before the option matures the option will not exist.
Typical Use

Knock-in options are generally used in conjunction will standard options to

construct cost-effective hedging strategies.

Exporter Example
Exposure
You are an New Zealand based exporter with a US$ 10,000,000 receipt due in six
months. At that time you will need to buy NZ$. The current spot price is US$ 0.5000 and
the six month forward price is US$ 0.5010.
Market View
You are unsure of the future direction of the New Zealand dollar against the US dollar but
you expect it to trade in a reasonably narrow range. You wish to protect yourself against
an adverse currency movement but would like to gain from a depreciation in the NZ$.
Possible Solution
You purchase a standard NZ$ call with a US$ 0.5000 strike price and sell a knock-in NZ$
put also with a strike price of US$ 0.5000 and a knock-in level of US$ 0.4700. This is a
zero cost strategy.
Outcome
1. If the NZ$/US$ exchange rate is below US$ 0.5000 at expiry, and during the life of the
option the market has traded at US$ 0.4700 so that the knock-in option has come into
being, then the bank would exercise its option and you would deal at US$ 0.5000.
2. If the NZ$/US$ exchange rate is above US$ 0.5000 you would exercise the NZ$ call
option.
3. If the NZ$/US$ exchange rate is below US$ 0.5000 at expiry, and has not traded at
US$ 0.4700 during the life of the option, then both options lapse and you deal at the
market rate.
Average Strike Rate Option Example
Exposure
You are an New Zealand subsidiary of a foreign company which must, at the end of each
year, translate profits at an average exchange rate. The required averaging dates are the
end of each month. In order to repatriate the profits in one year you will need to sell
NZ$. Current spot price is 0.5700 and the one year forward rate is 0.5750.
Market View

You are unsure of the future direction of the NZ$. You want to protect yourself against an
adverse currency movement but would like to benefit from any appreciation in the NZ$.
Possible Solution
You purchase an NZ$ Put Average Strike Rate Option with averaging dates at the end of
each month. This would cost 2.70% of the US$ amount
Outcome
1. If the average rate at year end is above the spot rate at expiry you exercise the option
and the bank will pay the difference between the average rate (the rate at which you
have translated your profits) and the spot price (the rate at which you can deal in the
market at that time).
2. If the average rate is below the spot price at expiry the option is allowed to lapse as
you have dealt at more advantageous average rates in the spot market.
Average Spot Rate Option Example
Exposure
You are an New Zealand company that exports US$ 1 million worth of goods to the US
each month. You want to protect your receivables over the next 12 months. The current
spot price is 0.5700.
Market View
You are unsure of the future direction of the NZ$. You want to protect yourself against
adverse currency movements but would like to benefit from any appreciation in the NZ$.
Possible Solution
You purchase an NZ$ call Average Spot Rate Option with a strike of 0.5000 and averaging
dates at the end of each month. This option will cost 1.85% of the US$ amount.
During the period, on each averaging date, you simply sell the US dollars you receive in
the spot market for New Zealand dollars. By dealing as close to 4 p.m. as possible you
can ensure that the average rate you effectively deal at over the year is very close to the
average rate used to settle the Average Spot Rate Option.
Outcome
At the end of the period you will have effectively dealt at the average rate for the period.
1. If the average rate for the period is greater than 0.5000 you will exercise your option
and your bank will pay you the difference between the average rate and the 0.5000
strike price. The amount you receive will effectively lower your actual dealing rates on
average, to 0.5000 (provided the basis risk between the rate source for the averaging
process and the rate you actually deal at each month is minimal).
2. If the average rate is below 0.5000 you would allow the option to lapse. In this case
you will have benefited from the more advantageous averaging rate over the period in
your monthly dealings.
Advantages

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Protection from adverse movements in exchange rates coupled with the flexibility
to take advantage of favourable movements if they occur.
Structures tailored to your requirements as to strike price, averaging dates, expiry
date and amount to be averaged at each date.
Cost effective relative to a standard option.
Simplifies exposure management. Changes to payments need not cause changes
to the option.

Disadvantages

Premium Payable up-front.

Net settlement occurs only at end and thereby not matching cash flows. Basis risk
between settlement rate (a mid point) and actual dealing rate.

Basket Options

Purpose
Basket options have been designed to provide portfolio managers with a cost-effective
solution to managing multi-currency exposures on a consolidated basis.
Description
A basket option has all the characteristics of a standard option, except that the strike
price is based on the weighted value of the component currencies, calculated in the
buyer's base currency. The buyer stipulates the maturity of the option, the foreign
currency amounts which make up the basket, and the strike price which is expressed in
units of the base currency.
At expiry, if the total value of the component currencies in the spot market is less
favourable than the strike price of the basket option the buyer would let the option lapse.
If it is more favourable, the buyer would exercise the option and exchange all of the
component currencies for the pre-specified amount of base currency (i.e. the strike price
of the option).
A basket option can cost significantly less than multiple single currency options. The
lower the correlation between the various currency pairs which make up the basket the
greater the cost saving.
Typical Use

A fund manager looking to protect the total value of a basket of currencies against
unfavourable currency movements.

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