1. The Currency Futures and Options Markets
Foreign Currency Options
Options - General
Currency Options
Quotations
Foreign Currency Speculations
Lecture 4

2. Foreign Currency Options
Option: A contract that gives the option buyer (holder) the right (not obligation) to buy or sell a given amount of the underlying asset at a fixed price (exercise price) over a specified period of time (or at a specified date).
Underlying asset: e.g stock, commodities, stock indices, foreign currency etc.
Rule for exercise:
American - exercisable anytime until expiration
European - exercisable only at expiration
Types of option:
Call option: option to buy the underlying asset (e.g. foreign currency
Put option: option to sell the underlying asset
Lecture 4

3. Foreign Currency Options cont’d
Example: a $60 call (expiration in 3 months) on an ABC stock; option premium $1
Holder exercises if the spot price > $60
Payoff Profile
S X= Premium Payoff
$50 (60) (1) -1 “out of the money
55 (60) (1) -1
60 (60) (1) -1 “at the money”
62 (60) (1) 1
67 (60) (1) 6 “in the money
Payoff
X=60 61 -1 S
Lecture 4

4. Foreign Currency Options cont’d
Payoff Profile - Call option on DM
1 option is for purchase of DM62,500
exercise price $0.5850/DM
Option Premium $0.0050/DM or $312.50
option in the money for spot >
option at the money for spot =
out of the money for spot <
Breakeven price = $0.5900/DM
Payoff Profile - Put Option on DM
option premium $0.0050/DM
option in the money for spot <
at the money for spot =
out of the money for spot >
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5. Foreign Currency Options cont’d
Lecture 4

6. Foreign Currency Options cont’d
Lecture 4

7. Foreign Currency Options cont’d
A forward obligation
Consider a £1 million obligation due in four months
Underlying transaction
Currency exposure
Lecture 4

8. Foreign Currency Options cont’d
A forward Hedge
This exposure can be hedged by purchasing £1 million in the forward market
Long pound forward
Lecture 4

9. Foreign Currency Options cont’d
An option hedge
A currency option is like one-half of a forward contract
An option to buy pound sterling at the current exchange rate
the option holder gains if pound sterling rises
the option holder does not lose if pound sterling falls
Long pound call
(option to buy
pound sterling)
Lecture 4

10. Foreign Currency Options cont’d
Currency option quotations
British pound (CME)
£62,500; cents per pound
Strike Calls-Settle Puts-Settle
Price Oct Nov Dec Oct Nov Dec
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11. Foreign Currency Options cont’d
The time value of an option is the difference between the option’s market value and its intrinsic value if exercised immediately.
The time value of a currency option is a function of the following six determinants:
Underlying exchange rate
Exercise price
Riskless rate of interest in currency d
Riskless rate of interest in currency f
Time to expiration
Volatility in the underlying exchange rate
Lecture 4

12. Foreign Currency Options cont’d
Lecture 4

13. Foreign Currency Speculation
Speculation - Trading on the basis of expectations about future prices
Speculation in Spot Markets
Speculation in Forward Markets
occurs if one believes that the forward rate differs from the future spot rate
if expect Forward < future spot, buy currency forward
if expect Forward > future spot, sell currency forward
Speculation using options
call options
put options
Speculation via Borrowing and Lending: Swaps
Speculation via Not Hedging Trade
Speculation on Exchange-Rate Volatility
Lecture 4