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
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
