Foreign Currency Options

1
(No Transcript)
2
Foreign Currency Options

• A foreign currency option is a contract giving
  the option purchaser (the buyer)
• the right, but not the obligation,
• to buy or sell a given amount of foreign exchange
  at a fixed price per unit
• for a specified time period (until the expiration
  date).

3
Foreign Currency Options

• There are two basic types of options
• A call option is an option to buy foreign
  currency.
• A put option is an option to sell foreign
  currency.
• A buyer of an option is termed the holder the
  seller of an option is referred to as the writer
  or grantor.

4
Foreign Currency Options

• There are two basic types of options
• A call option is an option to buy foreign
  currency.
• A put option is an option to sell foreign
  currency.
• A buyer of an option is termed the holder the
  seller of an option is referred to as the writer
  or grantor.

5
Foreign Currency Options

• An American option gives the buyer the right to
  exercise the option at any time between the date
  of writing and the expiration or maturity date.
• A European option can be exercised only on the
  expiration date, not before.

6
Currency Options Markets

• December 10th, 1982, the Philadelphia Stock
  Exchange introduced currency options. Growth has
  been spectacular.
• OTC currency options are not usually traded and
  can only be exercised at maturity (European).
  Used to tailor specific amounts and expiration
  dates.

7
Philadelphia Exchange Options
8
Philadelphia Exchange Options
The indicated contract price is 62,500 ?
0.0125/ 781.25
One call option gives the holder the right to
purchase 62,500 for 56,250 ( 62,500 ? 0.90/)
One call option gives the holder the right to
purchase 62,500 for 56,250. This option costs
781.25.
9
Reading the WSJ Currency Options Table

• The option prices are for the purchase or sale of
  one unit of a foreign currency with U.S. dollars.
  For the Japanese yen, the prices are in
  hundredths of a cent. For other currencies, they
  are in cents.
• Thus, one call option contract on the Euro with
  exercise price of 90 cents and exercise month
  January would give the holder the right to
  purchase Euro 62,500 for U.S. 56,250. The
  indicated price of the contract is
  62,500 ? 0.0125 or 781.25.
• The spot exchange rate on the Euro on 12/15/00 is
  88.15 cents per Euro.

10
Value of Call Option versus Forward Position at
Expiration
A call option allows you to obtain only the nice
part of the forward purchase.
11
Call Option Value at Expiration

• To summarize, a call option allows you to obtain
  only the nice part of the forward purchase.
  Rather than paying X for the foreign currency (as
  in a forward purchase), you pay no more than X,
  and possibly less than X.

12
Option Premiums and Option Writing

• Likewise, a firm that expects to receive future
  Euro might acquire a put option on Euro.
• The right to sell at X ensures that this firm
  gets no less than X for its Euro.
• Thus, buying a put is like taking out an
  insurance contract against the risk of low
  exchange rates.

13
Option Premiums and Option Writing

• Like any insurance contract, the insured party
  will pay an insurance premium to the insurer (the
  writer of the option).
• The price of an option is often called the option
  premium and acquiring an option contract is
  called buying an option.
• As with ordinary insurance contracts, the option
  premium is usually paid up-front.

14
Using Currency Options to Hedge Currency Risk

• Suppose you expect to receive 10,000,000 euros in
  6 months. Without hedging, your underlying
  position looks like this

15
(No Transcript)
16
If you also buy a put option with a strike price
of .90 for .01, your underlying position looks
like this.
17
Pricing Options

• Consider a euro call option that has a strike
  price of .90 and that is selling for .04.
• If the spot price is .93, the option must be
  worth at least .03. This is called the intrinsic
  value of the option.
• If the option is selling for more than the
  intrinsic value, the difference (in the example,
  .04-.03.01) is called the time value. We might
  just as well call it the hope value, since it
  represents the owners hope that the spot price
  will go up by even more.

18
Pricing Options

• Consider a euro call option that has a strike
  price of .90 and that is selling for .04.
• If the spot price is .93, the option must be
  worth at least .03. This is called the intrinsic
  value of the option.
• If the option is selling for more than the
  intrinsic value, the difference (in the example,
  .04-.03.01) is called the time value. We might
  just as well call it the hope value, since it
  represents the owners hope that the spot price
  will go up by even more.

19
We think about volatility in prices as being a
bad thing, and for most financial assets this is
true. A stock whose price fluctuates wildly is
less desireable (all other things the same) than
a more stable stock. But an interesting thing
about options is that their value is actually
enhanced by volatility of the underlying asset
value.

• Suppose you owned a euro call option with a
  strike price of .90.
• Imagine that you thought there was a 50 chance
  the euro would fall to .87 and a 50 chance you
  thought the euro would increase to .93 before
  expiration of the contract. This means there is
  a 50 chance that you will make .03.
• Imagine now that you changed your mind and
  decided there was a 50 chance the euro would
  fall to .85 and a 50 chance you thought the euro
  would increase to .95 before expiration of the
  contract. You now believe there is a 50 chance
  you will make .05 and so you should be willing to
  pay more for the option.

20
Pricing Options the role of interest rates

• Consider two different investment portfolios
• Portfolio A consists of
• A bond that will pay X at maturity
• The bond costs X/(1rus) where rus is the US
  interest rate
• A call option with a strike price of X
• The option will pay S-X if SgtX and 0 if SltX
• The option costs C
• Thus
• If StltX, you get X
• If StgtX, you get St-XX St

21

• Portfolio B is made up by
• Making a loan of S0/(1rforeign) units of the
  foreign currency, where S0 is the current spot
  rate and rforeign is the foreign interest rate.
• When the loan matures, you get St units of the
  domestic currency. A bond that will pay X at
  maturity

22
Conclude Portfolio A is better than Portfolio B
(A never returns less than X and B returns less
than X if StltX)

• But this implies that B can never sell for more
  than A
• That is
• CX/(1rus) gt S0/(1rforeign)
• or
• Cgt S0/(1rforeign)-X/(1rus)

23
(No Transcript)