Currency Derivatives:

Options

Ebru Reis
İstanbul Bilgi University
Outline
• Option Contracts
• Currency Option Markets
• Currency Futures Options
• Profit/Loss: Puts and Calls
• Option Pricing
– Black and Scholes Formula
– Empirical Tests
• Hedging with Options
What is an Option?
• An option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset in the future, at
prices agreed upon today.
• Calls vs. Puts
– Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at
some time in the future, at prices agreed upon today.
– Put options gives the holder the right, but not the
obligation, to sell a given quantity of some asset at
some time in the future, at prices agreed upon today.
European vs. American options
– European options can only be exercised on
the expiration date.
– American options can be exercised at any
time up to and including the expiration date.
– Since this option to exercise early generally
has value, American options are usually
worth more than European options, other
things equal.
Terminology
• In-the-money
– The exercise price is less than the spot price of the
underlying asset.
• At-the-money
– The exercise price is equal to the spot price of the
underlying asset.
• Out-of-the-money
– The exercise price is more than the spot price of the
underlying asset.
Currency Options Markets
• PHLX
• HKFE
• 20-hour trading day.
• OTC volume is much bigger than exchange
volume.
• Trading is in six major currencies against the
U.S. dollar.
PHLX Currency Option
Specifications

Currency Contract Size

Australian dollar AD50,000
British pound £31,250
Canadian dollar CD50,000
Euro €62,500
Japanese yen ¥6,250,000
Swiss franc SF62,500
Currency Futures Options
• Are an option on a currency futures contract.
• Exercise of a currency futures option results in a long
futures position for the holder of a call or the writer of a
put.
• Exercise of a currency futures option results in a short
futures position for the seller of a call or the buyer of a
put.
• If the futures position is not offset prior to its expiration,
foreign currency will change hands.
Currency Futures Options
• Why a derivative on a derivative?
• Transactions costs and liquidity.
• For some assets, the futures contract can have lower
transactions costs and greater liquidity than the
underlying asset.
• Tax consequences matter as well, and for some users
an option contract on a future is more tax efficient.
• The proof is in the fact that they exist.
Currency Call Options
• Firms with open positions in foreign currencies may use
currency call options to cover those positions.
• They may purchase currency call options
– to hedge future payables;
– to hedge potential expenses when bidding on projects; and
– to hedge potential costs when attempting to acquire other firms.
Currency Call Options
• Speculators who expect a foreign currency to appreciate
can purchase call options on that currency.
• Profit =selling price – buying (strike) price – option
premium
• They may also sell (write) call options on a currency that
they expect to depreciate.
• Profit = option premium – buying price + selling
price
Currency Call Option-
An Example
• Suppose call option premium = $0.0100,
option EX = $0.8100, and future spot rate =
$0.7900.
– Option buyer profit/loss = -$0.01
– Option writer profit/loss = +$0.01
• Now suppose future spot price = $0.8150.
– Buyer profit/loss = -0.01-0.81+0.8150= -$0.005
– Writer profit/loss = +0.01+0.81-0.8150 = +$0.005
Call Option
Profit
If the call is in-the-
money, it is worth
ST – E. Long 1
call
If the call is out-of-
the-money, it is
worthless and the ST
buyer of the call –c0
E + c0
loses his entire E
investment of c0.
Out-of-the- In-the-money
loss money
Put Option
Profit
If the put is in-the-
money, it is worth E – p0
E – ST. The
maximum gain is E
– p0
If the put is out-of-
the-money, it is ST
– p0
worthless and the
buyer of the put E – p0 long 1 put
loses his entire
E
investment of p0. In-the-money Out-of-the-
loss money
Call Option - Short
Profit

If the call is in-the-

money, the writer
loses ST – E.
If the call is out-of- c0
the-money, the
writer keeps the ST
option premium. E + c0
E
short 1
loss Out-of-the-money In-the- call
money
Put Option - Short
If the put is in- Profit
the-money, it is
worth E –ST.
The maximum
loss is – E + p0
If the put is out- p0
of-the-money, it
is worthless ST
and the seller E – p0 short 1
of the put E put
keeps the
option premium – E + p0
of p0. loss
Currency Put Options
• Speculators who expect a foreign currency to depreciate
can purchase put options on that currency.
• Profit =selling (strike) price – buying price – option premium
• They may also sell (write) put options on a currency that
they expect to appreciate.
• Profit = option premium + selling price – buying price
Currency Put Options –
An Example
• Suppose put option premium = $0.0100,
option EX = $0.8100, and future spot rate
= $0.7900.
– Buyer profit/loss = -0.01-0.79+0.81= $0.01
– Writer profit/loss = +0.01-0.81+0.79= -$0.01
• Now suppose future spot price = $0.8150.
– Buyer profit/loss = -$0.01
– Writer profit/loss = +$0.01
An Example
 Consider a call
option on £31,250.
 The option Profit
premium is $0.25
per pound
 The exercise price Long 1 call
is $1.50 per pound.
on 1 pound

–$0.25 ST
$1.75
$1.50

loss
An Example
Profit
 Consider a call
option on £31,250.
 The option
premium is $0.25 Long 1 call
per pound on £31,250
 The exercise price
is $1.50 per pound. – ST
$7,812.50
$1.75
$1.50

loss
An Example What is the maximum gain on this put option?

$42,187.50 = £31,250×($1.50 – $0.15)/£

Profit At what exchange rate do you break even?

$42,187.5
 Consider a put option 0
on £31,250.
 The option premium is
$0.15 per pound

– ST
 The exercise price is
$1.50 per pound. $4,687.50 $1.35 Long 1 put
$1.50 on £31,250
loss $4,687.50 = £31,250×($0.15)/£
Basic Option Pricing
Relationships at Expiry; Calls
• At expiry, an American call option is worth the
same as a European option with the same
characteristics.
• If the call is in-the-money, it is worth ST – E.
• If the call is out-of-the-money, it is worthless.
CaT = CeT = Max[ST - E, 0]
Basic Option Pricing
Relationships at Expiry : Puts
• At expiry, an American put option is worth the
same as a European option with the same
characteristics.
• If the put is in-the-money, it is worth E - ST.
• If the put is out-of-the-money, it is worthless.
PaT = PeT = Max[E - ST, 0]
American Option Pricing
Relationships
• With an American option, you can do everything that
you can do with a European option AND you can
exercise prior to expiry—this option to exercise early
has value, thus:

CaT > CeT = Max[ST - E, 0]

PaT > PeT = Max[E - ST, 0]

Market Value, Time Value and
Intrinsic Value for an American Call
Profit

The red line shows t Long 1

the payoff at r k e
Ma lue call
maturity, not profit, Va
of a call option.
Note that even an Intrinsic
out-of-the-money value ST
option has value— Time
time value. value
Out-of-the- In-the-money
money
loss E
• Intrinsic Value
– The difference between the exercise price of the
option and the spot price of the underlying asset.
• Speculative Value
– The difference between the option premium and the
intrinsic value of the option.

Option Intrinsic Speculative

= +
Premium Value Value
European Option Pricing
Black and Scholes Formula
 r$T
C
The model is 0  [ F  N ( d1 )  E  N ( d 2 )]e
Where
C0 = the value of a European option at time t = 0
F  S t e ( r$  r£ )T
r$ = the interest rate available in the U.S.
r£ = the interest rate available in the foreign country
—in this case the U.K.
ln( F / E )  .5 2T
d1  , d 2  d1   T
 T
Option Pricing- An Example
Find the value of a six-month call option on the British
pound with an exercise price of $1.50 = £1

The current value of a pound is $1.50

The interest rate available in the U.S. is r$ = 5%.
The interest rate in the U.K. is r£ = 7%.
The option maturity is 6 months (half of a year).
The volatility of the $/£ exchange rate is 40% p.a.
An Example – Contd.
Let’s try our hand at using the model. If you have a
calculator handy, follow along.
First
calculate F  St e ( r$  r£ )T  1.50e (.05.07 ) 0.50  1.485075
NORMSDIST
Function in Excel

N(d1) = N(0.106066) = .5422

N(d2) = N(-0.1768) = 0.4298

C0  [ F  N (d1 )  E  N (d 2 )]e  r$T

C0  [1.485075 .5422  1.50  .4298]e .05*.5  $0.157

Option Value Determinants
Call Put
1. Exchange rate + –
2. Exercise price – +
3. Interest rate in U.S. ? ?
4. Interest rate in other country ? ?
5. Variability in exchange rate + +
6. Expiration date + +

The value of a call option C0 must fall within

max (S0 – E, 0) < C0 < S0.

The precise position will depend on the above factors.

Empirical Tests
The European option pricing model works fairly
well in pricing American currency options.
It works best for out-of-the-money and at-the-
money options.
When options are in-the-money, the European
option pricing model tends to underprice
American options.
Hedging with Options (1A)
• US manufacturer has a C$50,000 obligation due during
the 3rd week of March
– Concerned that C$ will strengthen ($ weaken)
– Will need to buy C$
• Buy a Call!
– If cost of C$ is above exercise price, exercise option!
Otherwise, don’t.
– Call becomes more valuable as C$ value rises
Hedging with Options (1B)
• US manufacturer has a C$50,000 obligation due during
the 3rd week of March
– Concerned that C$ will strengthen ($ weaken)
– Will need to buy C$
• Sell a Put?
– If cost of C$ is above K, put won’t be exercised. Higher cost of
C$ is (partially) offset. If cost of C$ is below K, manufacturer is
obligated to buy C$ at K
Hedging with Options (2A)
• US manufacturer has a C$50,000 inflow expected
during the 3rd week of March
– Concerned that C$ will weaken ($ strengthen)
– Will need to sell C$
• Buy a Put?
– If value of C$ is above K, put won’t be exercised. If value of C$
is below K, manufacturer will exercise right to sell C$ at K
Hedging (1A & 1B)
• US manufacturer has a C$50,000 obligation expected
during the 3rd week of March
• Buy Call (must pay premium)
• Sell Put (only partial hedge if C$ increases)
• Do Both!
– Premium paid is offset by premium received
– Hedges both upside and downside potential