Chapter 10 - Currency options. In this chapter, the learning objectives are: 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.
Chapter 10 Currency Options 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 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 10-2 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 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 10-3 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 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 10-4 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 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 10-5 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 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 10-6 The mechanics of call and put options on the Australian dollar Call Put (a) Initial exchange Holder Writer Premium (USD) (b) Exercise Premium (USD) AUD AUD Holder Writer Holder Writer Holder Writer USD 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 USD 10-7 Naked and covered options • An option is naked if there is no corresponding spot position on the underlying currency 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 10-8 The exercise (strike) exchange rate • The exchange rate at which the holder of the option can buy or sell the underlying currency 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 10-9 Profitable exercise of call and put on currency y (b) Put gross profit = E S (a) Call gross profit = S E y y Writer Writer @ E @ E x x @ S Holder x Holder y x Spot market 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 @ S y Spot market 10-10 Long call 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 10-37 Long put 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 10-38 Long straddle 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 10-39 Short call 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 10-40 Short put 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 10-41 Short straddle 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 10-42 Long strangle 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 10-43 Short strangle 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 10-44 Factors determining option prices • • • • Exercise exchange rate Time to expiry Intrinsic value Exchange rate volatility (cont.) 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 10-45 Factors determining option prices (cont.) • Type of option • Interest rate on the base currency • Forward spread and interest rate differential 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 10-46 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 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 10-47 Exotic options • Exotic options are European-style options that offer alternative pricing, timing or exercise provisions to those of ‘conventional’ options (cont.) 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 10-48 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 (cont.) 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 10-49 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 (cont.) 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 10-50 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 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 10-51 ... can be exercised Copyright 2 010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 0- 15 American and European... Copyright 2 010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 0- 25 OTC and exchange-traded options • An OTC... Copyright 2 010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 0- 27 Differences between OTC and exchange-traded