1. Chapter 10 Currency Options

2. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Objectives To introduce basic concepts To outline the differences between OTC and exchange-traded options To describe option positions To identify the determinants of option premiums To describe exotic currency options 10-2

3. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Definition A currency option is a contract that gives its holder the right to buy or sell, on or by a specified date, an amount of a currency at a predetermined exchange rate 10-3

4. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Options writers and holders The writer sells the holder the right to buy or sell the underlying currency The price paid up front is called the premium 10-4

5. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Payment and settlement dates The premium payment date is the date on which the premium is due The settlement date is the date on which delivery of the underlying currency is required 10-5

6. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Call and put options A call option gives the holder the right to buy the underlying currency A put option gives the holder the right to sell the underlying currency 10-6

7. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa The mechanics of call and put options on the Australian dollar Call (a) Initial exchange Premium (USD) Put Premium (USD) Writer Holder (b) Exercise USD AUD USD Writer HolderWriter Holder Writer Holder 10-7

8. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Naked and covered options An option is naked if there is no corresponding spot position on the underlying currency 10-8

9. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa The exercise (strike) exchange rate The exchange rate at which the holder of the option can buy or sell the underlying currency 10-9

10. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Profitable exercise of call and put on currency y y Writer Holder @ E Spot market x y @ S x (a) Call gross profit = S - E Writer Holder @ E Spot market x y @ S x y (b) Put gross profit = E - S 10-10

11. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Profitable exercise of call and put options on the Australian dollar AUD 1,000,000 Holder Spot market (a) Call gross profit = USD 50,000 S = 0.65 E= 0.60 Writer AUD 1,000,000 USD 600,000 USD 650,000 AUD 1,000,000 Writer Holder E= 0.60 Spot market USD 600,000 S = 0.55 (b) Put gross profit = USD 50,000 AUD 1,000,000 USD 550,000 10-11

12. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa The settlement exchange rate The exchange rate at which the underlying currency can be bought or sold when the option is exercised 10-12

13. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Net settlement payments on successful exercise Writer Holder Premium K ( S – E ) (a) Call Writer Holder Premium K ( E – S ) (b) Put 10-13

14. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Long and short positions The holder of an option has a long position The writer of an option has a short position 10-14

15. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Expiry date The date by or on which the option can be exercised 10-15

16. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa American and European options An American option can be exercised before or on the expiry date A European option can be exercised on the expiry date only 10-16

17. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa In the money and out of the money An option is in the money if it can be exercised at gross profit An option is out of the money if it cannot be exercised at gross profit An option is at the money if the spot rate is equal to the exercise rate 10-17

18. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Intrinsic value and time value The intrinsic value is the extent to which the option is in the money The time value is derived from the possibility that with the passage of time the option will be in the money 10-18

19. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Assignment An assignment materialises when the writer receives a notice that the holder has exercised the option, in which case the writer is obliged to deliver or receive the underlying currency 10-19

20. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Base and underlying currencies The base currency is the currency in which the option price is expressed The underlying currency is the currency that is bought or sold 10-20

21. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Margins A margin is the cash or securities required to be deposited by an option writer as collateral 10-21

22. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Open Interest Open interest is the number of outstanding options 10-22

23. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Opening and closing transactions An opening transaction results in opening a new position A closing transaction results in liquidating an existing position 10-23

24. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Registered options traders ROTs are participants on the exchange, trading for their own or their firm’s account 10-24

25. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Option quotations American terms mean that the underlying exchange rate is quoted in terms of the US dollar per unit of the other currency European terms mean that the underlying exchange rate is quoted in terms of the other currency per unit of the US dollar 10-25

26. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa OTC and exchange-traded options An OTC option is non-standardised, created by the writer to meet the specific requirements of the buyer An exchange-traded option is a standardised option traded on an exchange 10-26

27. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Currency option specifications Contract size Position limit Base currency Underlying currency Premium quotations 10-27

28. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Differences between OTC and exchange-traded options The counterparty to every transaction on an organised exchange is the clearing corporation. In the OTC market it is another trader Prices are visible in an organised exchange but are not in the OTC market 10-28 (cont.)

29. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Differences between OTC and exchange-traded options (cont.) Margins are required for short positions in an organised exchange but are not in the OTC market Positions must be marked on a daily basis in an organised exchange but this is not the case in the OTC market 10-29

30. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Currency options traded on the Philadelphia stock exchange 10-30

31. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Actions and gross payoffs 10-31

32. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Net pay-offs on option positions Net pay-offs take the premium into account. For example, the net pay-off on a long call is: S -E - R 10-32

33. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Long straddle Obtained by buying call A and buying put A. It is used when the currency is expected to appreciate or depreciate dramatically 10-33

34. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Short straddle Obtained by selling call A and selling put A. It is used when the currency is not expected to move much 10-34

35. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Long strangle Can be obtained by buying call B and buying put A. It is cheaper than a straddle 10-35

36. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Short strangle Can be obtained by selling put A and selling call B 10-36

37. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Long call 10-37

38. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Long put 10-38

39. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Long straddle 10-39

40. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Short call 10-40

41. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Short put 10-41

42. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Short straddle 10-42

43. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Long strangle 10-43

44. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Short strangle 10-44

45. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Factors determining option prices Exercise exchange rate Time to expiry Intrinsic value Exchange rate volatility 10-45 (cont.)

46. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Factors determining option prices (cont.) Type of option Interest rate on the base currency Forward spread and interest rate differential 10-46

47. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Measures of sensitivity Delta:premium with respect to spot exchange rate Gamma:delta with respect to spot exchange rate Theta:premium with respect to time to expiry Vega:premium with respect to volatility Rho:premium with respect to interest rate 10-47

48. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Exotic options Exotic options are European-style options that offer alternative pricing, timing or exercise provisions to those of ‘conventional’ options 10-48 (cont.)

49. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Exotic options (cont.) The knockout option is also known as down-and-out option, barrier option, extinguishable option and activate/deactivate option It is designed to offer downside protection but only a limited upside range before crossing a previously specified barrier or knockout level at which it expires automatically 10-49 (cont.)

50. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Exotic options (cont.) The value of a path-dependent option depends on the average value of the spot exchange rate over a specified period A compound option is an option on an option. It gives the holder the right to buy or sell an option on a specific future date 10-50 (cont.)

51. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa Exotic options (cont.) A chooser option allows the buyer to lock in (in advance) a specific exercise exchange rate, amount and maturity. At a later date the choice is made between making the option a call or a put 10-51