With a call option, the holder of the option has the right but not the obligation to buy an asset. Essentially, the buyer of a currency call option has the right to buy (take delivery of) a predetermined amount of one currency in exchange for a predetermined amount of another currency up to a predetermined date and at a predetermined exchange rate. The writer of a currency call option has the obligation to sell (deliver) a predetermined amount of one currency in exchange for a predetermined amount of another currency up to a predetermined date and at a predetermined exchange rate.

For example, a call option of Swiss francs against the dollar, expiring in three months' time, for 10 million francs, struck at an exchange rate of 1.67 francs per dollar. (The specified exchange rate in an option contract is known as the exercise or strike price). The buyer of the call option has the right to receive ten million francs from the call option writer and deliver to the writer 5,988,023.95 dollars (10 million francs divided by 1.67 francs per dollar) The writer of this call option, therefore, has the obligation to deliver 10 million francs to the call option buyer in exchange for 5,988,023.95 dollars, at any time up to and including the three-month expiry date.

In the case of a put option, the holder has the right but not the obligation to sell an asset. The buyer of a currency put option has the right to sell (deliver) a predetermined amount of one currency in exchange for a predetermined amount of another currency up to a predetermined date and at a predetermined exchange rate. The writer of a currency put option has the obligation to buy (take delivery of) a predetermined amount of one currency in exchange for a predetermined amount of another currency in exchange for a predetermined amount of another currency up to a predetermined date and at a predetermined exchange rate.

For example, take a put option on Swiss francs against the dollar, expiring in three months time, for 6 million Swiss francs struck at an exchange rate of 1.50 francs per dollar. The buyer of the put option has the right to deliver 6 million Swiss francs to the put option writer in exchange for four million dollars (6 million francs divided by 1.50 francs per dollar) from the option writer. This right expires in three months' time. The writer of this put option, thus, has the obligation to receive 6 million francs from the option holder in exchange for $4 million, at any time, up to and including the three-month expiry date.

The differences between a call and a put option can be shown thus:

Foreign exchange options can be traded on an exchange or in the OTC market (that is, between two parties). Exchange-traded options are standardized contracts with fixed maturity dates, strike prices, and contract sizes, although each exchange has its own contract specifications and trading rules. OTC option specifications are much more flexible as maturity, strike price, amount, and the like can be negotiated before dealing.

Exchange-traded options can be characterized by:

One major advantage of standardized contracts is that the exchange acts as the counterparty to each trade. Credit risk (the risk of the writer defaulting on the option) is therefore minimized, and anonymity between counterparties can be preserved. It should be noted that currency options on the Chicago Mercantile Exchange (CME) are options on futures rather than options on the spot currency. Hence, if a call is exercised, the buyer receives a long futures position rather than a spot position and the opposite for the buyer of a put.

OTC options have the following characteristics:

For example, Bank A buys from Bank B a 1.5700 European-style sterling call/dollar put on 10 million pounds, with a maturity of six months. Bank A buys the option through the OTC market for a premium of $0.02 per £1 principal. In this example:

The users of the option market are widespread and varied, but the main users are organizations whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange-traded option markets will be accessed by the professional market makers and currency risk managers. The standardization of options contracts promotes trad-ability, but this is at the expense of flexibility.

In spite of the fact that options are becoming more and more popular with corporate clients, funds, and private individuals, there is still some client resistance to using options to mange currency exposures. Some clients consider options to be expensive and/or speculative. When you buy an option, the most you can lose is the premium (price paid for the option). In some cases, options can help minimize downside risk, while allowing participation in the upside potential. One of the reasons a client may choose to use an option instead of a forward to manage their downside risk is this opportunity to participate in the upside profit potential, which is given up with a forward contract. Clients who buy currency options enjoy protection from any unfavorable exchange rate movements. This can be seen in Figure 66.1.

Figure 66.1. Foreign Exchange Considerations

Figure 66.2. Exposure Management Decision Tree

Companies use currency options to hedge contingent/economic exposures, hedge an existing currency exposure, and possibly profit from currency fluctuations, while funds may use options to enhance yield.

A simplified decision tree as to when to use options, or the various other products available, can be quite useful. The decision-making process assumes a firm view of likely future rate movements, as indecisiveness can only be accommodated by the use of currency options, which can be an expensive solution for many hedging requirements. The more confident the forecast, the simpler the products needed to satisfy needs. The simpler the product, the cheaper the cost. If the forecast is confident that rates will be favorable, then it is best to stay unhedged or to take out an option with the full confidence that the premium cost will be recovered, as the option means that any unexpected downturn will be catered for. Similarly, if no change is expected, then the position should be covered with the cheapest hedge possible. A confident forecast that rates will be unfavorable would call for a forward contract. An example of an exposure management decision tree is shown in Figure 66.2.

Sometimes a strategy may involve more than one option, and some option strategies employ multiple and complex combinations. Certain combinations can yield a low- or no-cost option strategy by trading off the premium spent on buying an option with the premium earned by selling an option.

Hence, in buying a currency option, it may help by limiting downside currency fluctuation risk while retaining upside potential, providing unlimited potential for gain, providing a hedge for a contingent risk, and enabling planning with more certainty. On the other side of the coin, in selling a currency option, it may assist in providing immediate income from premium received and provides flexibility when used with other tools as part of an exchange rate strategy.

Table 66.1 summarizes the applications of foreign exchange options.

For a hedger, in terms of exchange rate risk management, currency options can be used to guarantee a budget rate for a transaction. By buying a call (the right to buy), the maximum cost can be fixed for a purchase; and by purchasing a put (the right to sell), the minimum size of a receipt can be fixed. The purchase of the option involves paying a premium but gives the buyer the full protection against unfavorable moves while retaining full potential to profit should rates subsequently move beneficially. This contrasts with a forward contract, which locks the hedger into a fixed exchange rate, where no premium is payable but no benefit can be taken from subsequent favorable moves.

In the case of trading, to assume risk in order to make a profit, traders use options to benefit from both directional views and/or changes in volatility. (This allows profit to be made from expecting volatility to either increase or decrease over a period of time.) For example, in order to take a directional view, an options trader might feel strongly that the dollar will strengthen against the Swiss franc in the next three months from its current level of USD/CHF 1.66. The trader buys a dollar call (right to buy), Swiss franc put (right to sell) option with a strike price of 1.6835, with expiry in three months' time.

The trader has two choices: to hold the option to expiry and if the spot rate has risen to, for example, USD/CHF 1.73, the trader would exercise his right to buy dollars and sell Swiss francs at 1.6835 and, hence, make money. If the spot rate is below USD/CHF 1.6835 at expiry, then the maximum loss is limited to the premium paid for the option. Alternatively, if the spot rate rises, say one month after the trader has purchased the option, the trader could choose to sell the option back. By doing this, the trader will recoup both the time value and intrinsic value of the option.

Quite often, there really seems to be little point in paying a premium for an option when a foreign exchange forward would suffice, but the benefits of an option really do have to be considered. The differences between OTC foreign exchange options and foreign exchange forwards are summarized in Table 66.2 The differences between buying an OTC foreign exchange option and leaving the position unhedged (that is, leaving the position open) are summarized in Table 66.3.

There are two parties involved in foreign exchange options: the option buyer and the option seller (writer). The option buyer has the right to demand fulfilment of the option contract. The owner can exercise the option. The option buyer pays a premium for that right. The option seller (writer) grants the right and receives a premium for accepting the obligation to fulfil the option contract, if the buyer demands. Table 66.4 provides a summary of the risk profile of an options buyer/seller.

Just like with spot and forward foreign exchange contracts, there are risks involved in currency options. If the option expires worthless (that is, is not exercised), then there is no real credit risk. There is transaction-related risk if it is exercised, which is similar to risk on a spot settlement. Because an option buyer enjoys the dual benefits of insurance and upside potential, the option seller/writer is subject to a greater degree of market/price risk than when it enters into a forward contract. As for country risk, it is similar to that for forwards and swaps. Table 66.5 provides an expanded summary of the risk profile of an options buyer/seller.

Because a foreign exchange transaction is, by definition, an exchange of one currency for another, the purchase of one currency is also the sale of another currency. Therefore, the right to buy one currency is also the right to sell another currency. For example, the owner of a Swiss franc call option has the right to buy Swiss francs and also has the right to sell dollars. The writer of a Japanese yen put option is also the writer of a dollar call option. Hence, the terms "call" and "put" option in foreign exchange are interchangeable.

This can be a source of some confusion in the market. For example, a call option struck at a dollar/Japanese rate of 130, is it the right to buy dollars or to buy Japanese yen? Indeed, there is no definitive answer and much depends on the viewpoint of the user and whether the dollar is seen as the base currency or the foreign currency. For the sake of clarity, it is common practice to use both terms, calls and puts. For example, a trader may well ask for a price for a Swiss franc call/dollar put at a strike of 1.67 in order to avoid this confusion.

As shown in the risk profile of an options buyer/seller, there is one very important factor to remember regarding currency options, in that for the buyer of an option, the maximum risk is limited to the premium paid, while for the option seller, the maximum profit is limited to the premium received and the seller is potentially exposed to unlimited losses. Additionally, because of the credit risk involved when writing options, typically there are fewer restrictions on those wishing to buy options than those who wish to sell.

Writing options on exchanges tends to be simpler as the credit risks are controlled by a margin system. The margin is a small percentage of the value of the contract, which must be deposited to cover losses up to a certain limit. The margin is usually adjusted on each trading day and occasionally more frequently to take account of market movements. However, the greater flexibility available in the OTC market allows some of the credit difficulties to be pursued and overcome. Participants in the foreign exchange currency options market include:

For example, a British-based company that exports consumer goods to several countries. Currently, the company has contracted to supply US$10 million worth of goods to America and expect to receive payment in three months time, in dollars. The company believe that the dollar will appreciate against sterling over the next three months. There are several alternative strategies:

The possible results are:

If the company decides to purchase a currency option, it could buy a three-month option, European-style sterling call/dollar put option, with a strike price of £/$1.75 (the right to buy sterling and sell dollars at a rate of £/$1.75). Assume the cost of the option is 1.74% of the sterling amount, that is, £99,428.57 ($10 million/1.75 = £5,714,285.71 × 1.74%). The outcome at maturity is:

In viewing whether an option should be viewed as a hedge or as a speculative instrument, a hedger's main concern is the value of the option at maturity. For this reason, any fluctuation of the option's intrinsic value during its life is important but any change in its time value is largely irrelevant. Also, as the option is itself a hedge, no further hedging is required and therefore there are no extra costs. The option premium for a hedger represents:

where:

For example, if the forward outright rate of the dollar against Swiss francs is 1.6000, then for a dollar call (right to buy), Swiss franc put (right to sell) option, with a strike of 1.5700, the intrinsic value of the option would be 0.0300 dollar against Swiss francs. For a dollar put (right to sell), Swiss franc call (right to buy) option, with a strike of 1.5700, then the intrinsic value of the option is 0.0000 dollar against Swiss francs.

In essence, time value represents the additional value of an option due to the opportunity for the intrinsic value of the option to increase and for a trader/speculator, the option premium represents the expected net present value of the cost of delta hedging the option.

A trader's main concern is the value of the option whenever it is marked-to-market. For this reason, any fluctuation in the intrinsic value of the option is important but also any change in the time value will be significant. If the trader, at any time, decided to hedge or partially hedge the option, extra transaction costs may be incurred, which might affect the overall return.

Options can be priced as European-style or as American-style options. The holder of a European-style option has the right to exercise the option only on the expiration date, while the writer of this option may be assigned only on the expiration date of the option. However, the holder of an American-style option has the right to exercise the option on any day until expiry, while the writer of an American-style option may be assigned on any day until expiry.

For example, if an option expires on March 28, with an American-style option, the holder could exercise the option on the March 5 and expect delivery of the currencies involved to take effect two business days later. With a European-style option, exercise can only occur on March 28, with delivery then two business days later. It must be remembered that there is a difference in price between the two styles of option, but only sometimes. The difference in price occurs because there is a difference in the interest rates each currency attracts. With American options, the intrinsic value is priced against the spot or the forward outright price, whichever is the most advantageous. This is because the American option can be exercised for spot value at any time during its life.

If the call currency of the option has a higher interest rate than the put currency, there will be an advantage in calculating the intrinsic value against spot rather than against the forward outright rate. Therefore, the risk that the writer has, is that at some point in time, if the option is so far in-the-money that there is negligible time value remaining, the holder may exercise early. This would mean the writer would incur the differential interest cost of borrowing the higher interest rate currency and lending the lower interest rate currency.

Hence, there is a price difference between the two styles of option, but only sometimes. The difference in price occurs because there is a difference in the interest rates each currency attracts. With American options, the intrinsic value is priced against the spot or the forward outright price, whichever is the most advantageous. This is because the American option can be exercised for spot value at any time during its life. If the call currency (right to buy) of the option has a higher interest rate than the put currency (right to sell), there will be an advantage in calculating the intrinsic value against spot rather than against the forward outright rate. Therefore, the risk that the writer of the American option has is that at some point in time, if the option is so far in-the-money that there is negligible time value remaining, the holder may exercise early. This would mean the writer would incur the differential interest cost of borrowing the higher interest rate currency and lending the lower interest rate currency. If this happens, the option is said to be at logical exercise.

As the American-style option is more flexible, shouldn't it be more expensive all the time? Actually, the American option is not really more flexible than the European option. True, it can be exercised early and therefore the intrinsic value can be realized immediately but unless the option is at logical exercise, the holder would be better to sell the option back and receive the premium. (Remember, the premium represents the intrinsic value of an option plus time value). This is true for both American and European options and in both cases, if the option is not at logical exercise, and the aim is to realize maximum profit, it would be better to sell than to exercise the option.

Examples of cases when it would be better to pay the extra premium and buy a more expensive American-style option are:

In buying an out-of-the-money option with interest rates as in both above and it is expected that the option will move significantly into the money, then the American-style option is more highly leveraged and will produce higher profits.

An in-the-money option is an option that describes an option whose strike price is more advantageous than the current market price of the underlying and has intrinsic value, that is, the extent to which it is in the money. For a call option, the strike is below the spot rate and for a put option, the strike is above the spot rate. For example, if the pound spot rate against the dollar is at £/$1.80, a $1.75 call on sterling is in-the-money, as is a $1.85 put on sterling. The more an option is in-the-money, the higher the intrinsic value and the more expensive it becomes. As an option becomes more in-the-money, its delta increases and it behaves more like the underlying in profit and loss terms. Hence, deep in-the-money options will have a delta of close to one.

Also, the option has time value, which is a mathematical function of implied volatility, time to maturity, interest rate differentials, spot and the strike of an option. It represents the additional value of an option due to the opportunity for the intrinsic value of the option to increase. However, it is difficult to quantify, as it is very subjective. It is a wasting asset, so time value declines as expiration approaches and at a more rapid rate.

Figure 66.3. Option "Moneyness" of a £/$1.80 Option

An option is said to be out-of-the-money when it has no intrinsic value and describes an option whose underlying is above the strike price in the case of a call, or below it in the case of a put. For a call option the strike is above the spot rate and for a put option, the strike is below the spot rate. Again, as above, using a spot rate of $1.80 per pound, a $1.85 sterling call and a $1.75 sterling put option are both out-of-the-money.

The more the option is out-of-the-money, the cheaper it is, since the chances of it being exercised gets slimmer. Its delta also declines and it becomes less sensitive to movements in the underlying.

An option that is at-the-money is one whose strike price is set at the same level as the prevailing market price of the spot or underlying forward contract. For example, with a pound against the dollar spot rate at $/£1.80, a $1.80 sterling call option is said to be at-the-money spot (see Figure 66.3).

In summary, intrinsic value is simply the difference between the spot price and the strike price.

For call options:

and for put options:

In addition, it should be noted that intrinsic value versus time value can be explained as:

A cause of some confusion in the market, which is more semantic than real, occurs when the forward or futures price differs from the spot. For example, if sterling against the dollar spot is $1.80 and the March forward/futures price is $1.75, the $1.80 sterling call for March could be said to be at-the-money against the spot but out-of-the-money against the forward/futures price. Alternatively, the $1.75 sterling call for March is in-the-money against the spot rate but at-the-money against the forward/future price. Thus, traders usually resolve these problems by using the terms "at-the-money spot" to refer to the $1.80 call and "at-the-money forward" to refer to the $1.75 call, in this particular example. Hence, with a Black-Scholes model, the delta of a European-style at-the-money forward option will always be 0.5. However, because forwards commonly trade at a premium or discount to the spot, the delta may not be equal to 0.5.

Theorists have devoted a substantial amount of work developing a mathematical model for pricing options and a number of different models exist as a result. All make certain assumptions about market behavior, which are not totally accurate but which give the best solution to the price of an option. Although the formulae for pricing options are complex, they are all based on the same pricing principles.

As mentioned earlier, the price of an option is made up of two separate components:

There are six factors that contribute to this pricing of an option:

For European-style options, intrinsic value is the value of an option relative to the outright forward price; that is, it represents the difference between the strike price of the option and the forward rate at which one could transact today. Intrinsic value can be zero, but it is never negative.

How should one ask for an option price? The required pieces of information, in the preferred order, are as follows:

There are many ways of stating the period, but usually, if one date is stated, it is assumed to be the expiry date but it is much safer to always specify. In the same way, if a 10-day option is requested, it is assumed that the required option has an expiry date 10 days from the current date. If, however, an option is requested with a period in terms of months or years (e.g., three months), the dates of the option are worked out as follows:

This gives the delivery date. The expiry date will then usually be two working days before that.

The exceptions occur in any currency pair where spot is not two working days, for example, the Canadian dollar, where the expiry date would be one working date before the delivery date.

Please note that with cross-currencies and dates involving American holidays or in any case where there may be confusion, it is always best to quote both the expiry and delivery dates required.

In asking for an option price, always state which currency is the call and which is the put. For example, does dollar Swiss franc (USD/CHF) put mean a dollar put or a Swiss franc put? On the option exchanges and in the OTC interbank market, this would usually refer to a Swiss franc put dollar call. However, most corporations would probably mean a dollar put. For this reason, always state the case in full (e.g., dollar call Swiss franc put or vice versa).

The preset price is called the strike price or the exercise price, which is the predetermined rate of exchange at which exercise takes place. The strike is usually chosen at a level close to the current foreign exchange spot or forward rate but may be at any reasonable level. The premium (price) of an option is very sensitive to the relationship of the strike to the current spot foreign exchange rate. However, in general, both buyers and sellers of options will select a strike rate based on several factors, including their forecast or expectations of the value of the underlying currency during the lifetime of the option and the option's payoff (profit/loss) profile.

In essence, when selecting a strike rate, the participant will need to consider the upfront premium payment, the break-even point (the point where gains begin), and the leverage of the given risk. If there are limited funds to spend on the premium, then an out-of-the-money strike, which is relatively inexpensive, reflecting less protection and higher leverage, will be chosen. This may, perhaps, be better understood by considering the Table 66.7. As for a person who is pricing up the requested option, Table 66.8 should be used:

In dealing with options, there are two main means for counterparties to enter into a transaction: live pricing or volatile pricing/quotation.

What does a "live price" mean? The price of an option is obviously dependent on the spot price in the market. As an option trader needs to delta hedge the option straightaway, the spot at which the trader can hedge is the rate the trader uses to price the option. If a price is being quoted live, it means that the person asking for the price will be quoted a premium price for the option and the option trader will take the risk that spot moves during the transaction.

The alternative to dealing live is to deal "with delta." This means that the person asking the price will deal the delta hedge with the option trader as well as the option.

The premium is normally quoted as a percentage of the base currency amount of the option. However, in the interbank market, it is normally quoted as pips per currency amount of the option. For example, if the option is a dollar/Swiss franc option, the premium can be quoted in the following ways:

If the option were being dealt in a round amount of dollars (e.g., $10 million), then either 1 or 3 would be the usual quote. If 2 or 4 were required, however, the Swiss franc amount of the option is found by multiplying the dollar amount by the strike of the option.

Table 66.8. Considerations for Price Maker

How can one form of premium be quoted to another? The following formula can be used:

For example, if a Swiss franc dollar option costs 2.05% dollar amount, spot is 1.5500 and the strike of the option is 1.5200, then

or

When an option is exercised, the physical exchange of the two currencies is effected and normally, settlement takes place in full; for example, if a dollar put (right to sell) Swiss franc call (right to buy) option is exercised, the full amount of the dollars will be paid to the option writer and the exerciser will receive the full amount of Swiss francs from the option writer. As mentioned before, settlement takes place on the delivery date unless the option is American and has been exercised early, in which case settlement takes place spot from the date the option is exercised.

Is it necessary to settle both amounts in full? No, it is possible to "net settle" the option. This means that only the profit on the option is paid from the writer to the holder of the option. If this is decided at the time of exercise, the writer will normally quote the holder a spot rate and if this rate is acceptable, the option profit will be determined accordingly. If net settlement is agreed at the time of the original deal, it may be necessary to have a more formal arrangement for determining the profit on the option at the time of exercise.

It is sufficient that the option writer receives notice of exercise before the exercise time on the expiry date. This time is 15.00 hours London time, 15.00 hours Tokyo or 10.00 hours New York time.

It is important to note that there is a significant difference between the expectations and the risks assumed by the three main different players in the currency options market. The first group—investors—typically look to use options in order to improve the risk/rewards ratio compared with entering a spot foreign exchange transaction. As such, the investor is concerned with the total cost of the option from which it can be determined by how far the market must move in order to profit. Therefore, the primary interest is usually on the delta, or magnitude of the position, and how moves in the market will impact their daily profits and losses. The volatility level is of lesser concern.

The second group—hedgers—are primarily concerned with protecting an existing exposure from adverse movements in the currency market. Often, these corporate treasuries are hedging profits from overseas offices or costs from international purchases. Performance is compared with benchmark foreign exchange rates or cost effective levels. In the past, such risks were generally hedged in the forward foreign exchange market, locking in acceptable rates without any potential for profit. Options now provide the protection required while offering opportunities to profit from beneficial movements in the foreign exchange rate.

Third, volatility traders, for example banks and other professional players, have sufficient capital to perform the important task of establishing competitive and liquid markets in currency options for the users mentioned. As such, the options trader may hold hundreds of open options positions. The primary risk being managed is of movements in the price of volatility, and the relationship between the time decay and the gamma positions.

As the market for currency options has expanded, the number of speculators in the volatility markets has also increased. Before computer systems were widely available to manage the complex and dynamic risks of an option portfolio, profits in the market were primarily transaction oriented, with most of the risk eventually falling into the hands of a small number of institutions. However, there are now many market participants who are willing to assume risk positions and there is a broad spectrum of players ranging from a pure market maker with little risk to a pure position taker making use of the available liquidity.

Also, the following risks should be taken note of: