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- 1. Introduction to Options FX, Derivatives and DCM workshop I
- 2. What is a Currency Option Contract? “A financial agreement giving the buyer the right (but not the obligation) to buy/sell a specified amount of currency at a specified rate on a specified date” 100% protection • 100% participation • FX, Derivatives and DCM workshop I
- 3. How does it compare to the Forward? “A financial contract whereby the owner has the obligation to buy/sell a specified amount of currency at a specified rate on a specified date” 100% protection • 0% participation • FX, Derivatives and DCM workshop I
- 4. Definitions The right to buy a specified amount of • Call Option currency at a specified rate The right to sell a specified amount of • Put Option currency at a specified rate The price of an option • Premium The rate at which the right can be exercised • Strike The date at which the right can be exercised • Expiry Date FX, Derivatives and DCM workshop I
- 5. Types of Options • OTC Options European style Option only exercisable on the expiry date Option American style Option exercisable at any time until expiry Option • Listed Options Chicago IMM, Philadelphia FX, Derivatives and DCM workshop I
- 6. Terminology Unlike futures and forward positions, you have to pay for an option. The amount you pay is known as the “Option Premium” The “Intrinsic value” of an option is how much you could get from exercising the option immediately. An American option premium, of course, will always at least as great as the option’s intrinsic value. The different between the option premium and the intrinsic value is known as the “Time Value” FX, Derivatives and DCM workshop I
- 7. Term – Cont’d • An Option is “in-the-money” if its intrinsic value is positive, and “out-of-the-money” otherwise. An at- the-money option is one with a strike price close to the underlying asset price. FX, Derivatives and DCM workshop I
- 8. Hedging: • Option can be used as investments, or to hedge the downside risk of an existing foreign currency exposure. In both cases, it is common to work with “payoff diagram”, which show what is the terminal payoff from holding a (European) option conditional on where the spot exchange rate ends up. That terminal payoff depends upon whether the spot exchange rate ends up above or below the strike price, and whether the option is a call or put. FX, Derivatives and DCM workshop I
- 9. Hedging – Cont’d • Buying options can offset the downside foreign currency risk of a position, while retaining the upside potential – at a cost. Options are “insurance” against bad realizations of the exchange rate. • Buying call options ensures the right to acquire foreign currency at a prespecified price (e.g., to pay off a future liability), while allowing you to forego that right if you can get a cheaper price in the spot market. FX, Derivatives and DCM workshop I
- 10. Hedging – Cont’d • Buying put options ensures the right to sell foreign currency (future accounts receivable) at a prespecified price, while allowing you to sell at a higher price in the spot market if chance premits. FX, Derivatives and DCM workshop I
- 11. Option VS Futures (FWD) profit The buyer of an option has the • right but not the obligation to perform Long futures Unlike the long futures Long call • strategy, the long call strategy has an asymmetric payoff Futures price The upside potential, however • is less than that for a futures strategy by an amount equal to the option price loss FX, Derivatives and DCM workshop I
- 12. Right VS Obligation Only Long long rights call put profit Option buyers rights Long Short loss futures futures price profit Option sellers obligations loss Only Short short obligations put call FX, Derivatives and DCM workshop I
- 13. The Four Basic Option Payoffs Thus, the four basic option positions - buy a call, sell a call, buy • a put, sell a put - can be summarized using a diagram: BUY BUY PUT CALL SELL SELL PUT CALL FX, Derivatives and DCM workshop I
- 14. What would an importer do? Underlying exposure is to pay suppliers USD (Short USD) To hedge this exposure, an importer needs to buy USD sell THB Buy USD Call THB Put Sell USD Put THB Call “at expiry, an importer has the “at expiry, an importer has the right to buy USD and sell THB” obligation to buy USD and sell THB” FX, Derivatives and DCM workshop I
- 15. Buy European USD Call European style USD Call/THB Put THB/USD Spot at Expiry Spot 43.00 > Strike: Option is exercised Strike 43.50 (value date = spot date) Expiry 3 months = Strike: Option expires without value Amount USD1,000,000 < Strike: Option expires without Premium 0.30 value FX, Derivatives and DCM workshop I
- 16. P/L at Expiry (Buy European USD Call) P&L 100% participation 100% protection below 43.50 above 43.50 Spot at expiry Upfront Premium 43.80 43.50 (Strike) FX, Derivatives and DCM workshop I
- 17. Sell European USD Put European style USD Put/THB Call THB/USD Spot at Expiry Spot 43.00 > Strike: Option expires without Strike 42.50 value Expiry 3 months = Strike: Option expires without value Amount USD1,000,000 < Strike: Bank exercises option Premium 0.30 (Granter inherits OTM position) FX, Derivatives and DCM workshop I
- 18. P/L at Expiry (Sell European USD Put) P&L 42.50 (Strike) Upfront Premium Spot at expiry 42.20 FX, Derivatives and DCM workshop I
- 19. What would an exporter do? Underlying exposure is to receive USD (Long USD) To hedge this exposure, an exporter needs to sell USD buy THB Buy USD Put THB Call Sell USD Call THB Put “at expiry, an exporter has the “at expiry, an exporter has the right to sell USD and buy THB” obligation to sell USD and buy THB” FX, Derivatives and DCM workshop I
- 20. Buy European USD Put European style USD Put/THB Call THB/USD Spot at Expiry Spot 43.00 > Strike: Option expires without Strike 42.50 value Expiry 3 months = Strike: Option expires without value Amount USD 1,000,000 < Strike: Option is exercised Premium 0.30 (value date = spot date) FX, Derivatives and DCM workshop I
- 21. P/L at Expiry (Buy European USD Put) P&L 100% protection below 42.50 100% participation above 42.50 Spot at expiry Upfront Premium 42.20 42.50 (Strike) FX, Derivatives and DCM workshop I
- 22. Sell European USD Call European style USD call/THB Put THB/USD Spot at Expiry Spot 43.00 > Strike: Bank exercises option Strike 43.50 (Granter inherits OTM position) Expiry 3 months = Strike: Option expires without value Amount USD1,000,000 < Strike: Option expires without Premium 0.30 value FX, Derivatives and DCM workshop I
- 23. P/L at Expiry (Sell European USD Call) P&L 43.50 (Strike) Upfront Premium Spot at expiry 43.80 FX, Derivatives and DCM workshop I
- 24. Call - Put Parity • From the diagram, we can see that: Long Forward = Long Call + Short Put Note: it holds only for European options of the same strike FX, Derivatives and DCM workshop I
- 25. RISK/REWARD CHARACTERISTICS FX, Derivatives and DCM workshop I
- 26. RISK/REWARD CHARACTERISTICS • The figures illustrate two of the most important characteristics of options: – buyer of options have limited risk and potential unlimited reward. – sellers of options have limited reward and potential unlimited risk. • So what will you do? Buy or sell.. FX, Derivatives and DCM workshop I
- 27. RISK/REWARD CHARACTERISTICS • You may realize that almost any trade in stock or futures market carries unlimited risk. • The limited or unlimited risk/reward characteristics of a trade are not the only considerations. At least as important is the probability of that unlimited profit or loss. FX, Derivatives and DCM workshop I
- 28. RISK/REWARD CHARACTERISTICS • Buying an option does not lead to a guaranteed gain, once the premium is taken into account. • If fairly priced, no single option can dominate any other option for all possible future outcomes. FX, Derivatives and DCM workshop I
- 29. Exercise Spot = 105.00 Buy $1 1-month 110 $ call Sell $1 1-month 115 $ call Buy $1 1-month 120 $ call • What is the payoff diagram (hockey stick)? • Can the structure be zero cost? FX, Derivatives and DCM workshop I
- 30. P/L Diagram 0 105 110 115 120 FX, Derivatives and DCM workshop I
- 31. P/L Diagram 0 105 110 115 120 FX, Derivatives and DCM workshop I
- 32. DIRECTION UNDECIDED ANDISING VOLATILITY P/L Long straddle – long straddle: Buy a call and buy a put with same strike, same maturity, and X same amount. spot – Long strangle: Buy a put P/L (lower strike) and buy a call Long strangle (higher strike), with same maturity and same amount. X1 X2 spot FX, Derivatives and DCM workshop I
- 33. Butterfly • Buy a straddle and sell a strangle with same notional and maturity P/L X2 X1 X3 FX, Derivatives and DCM workshop I
- 34. Risk Reversal • Buy a low delta $ call (put) and sell a low delta $ put (call) – e.g. Buy $1 mio 1-month 40 $ call Sell $1 mio 1-month 38 $ put P/L 38 39 40 FX, Derivatives and DCM workshop I
- 35. Some principals • The larger the potential positive payoff, the more expensive the option strategy • the way to reduce up-front cost is – reduce the potential positive payoff – increase the potential negative payoff – change the notional amount FX, Derivatives and DCM workshop I
- 36. BULLISH AND UNDECIDED VOLATILITY Bull spread • – Buy a call (X1) and sell a call (X2), with X1 < X2 – Buy a put (X1) and sell a put ((X2), with X1 < X2 P/L Bull spread X1 X2 FX, Derivatives and DCM workshop I
- 37. BEARISH AND UNDECIDED VOLATILITY Bear spread • – Sell a call (X1) and buy a call (X2), with X1 < X2 – Sell a put (X1) and buy a put ((X2), with X1 < X2 P/L Bear spread X1 X2 FX, Derivatives and DCM workshop I

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