Currency Options Explained

A "Currency/Forex option' is the right, without an obligation, to buy or sell one currency against another currency at a specified price, during a specified period.

Calls and Puts

A 'call' is the right without an obligation, to buy a currency. A 'put' is the right, without an obligation, to sell a currency.

In every foreign exchange transaction, one currency is purchased and another is sold. Consequently, every currency option is both a call and a put. An option to buy USD against JPY is both a USD call, and a JPY put.

Parties to an Option

There are two parties to an option - the buyer and seller. The buyer of the option enjoys the right to exercise the option and the right not to do so (ie to let it lapse). The seller of the option has an obligation to deal at the contracted rate if the buyer elects to exercise the option. The seller is also known as the 'writer' or 'grantor' of the option.

Option Premium

The price of the option is known as the 'option premium'. The buyer pays the premium to the seller as compensation for the risk involved in writing the option. The premium is normally paid on the spot value date from the date on which the option is contracted.

Value Terms

The 'strike price' or 'strike rate' is the exchange rate at which the option will be exercised if the buyer elects to exercise the option.

'In-the-money' (ITM) describes an option which would produce a profit if exercised (excluding consideration of the premium). 'Out-of-the-money' (OTM) describes an option which would produce a loss if exercised (excluding consideration of the premium). 'At-the-money' (ATM) describes an option which would produce neither a profit, nor a loss if exercised. The at-the-money strike price is the forward rate.

The premium will be higher if the option is in-the-money, and lower if the option is out-of-the-money.

Maturity of the Option

The 'expiration date' or 'expiry date' refers to the date on which the buyer's right to exercise ends. In practice, a specific expiry time (eg 10:00am New York time or 3:00pm Tokyo time on the expiry date) is agreed. If an option is exercised on the expiry date, the cash flows will occur on the then spot value date.

An 'American Option' refers to an option which can be exercised for spot value on an date between the contract date and the expiry date. A 'European option' refers to an option which theoretically, can only be exercised for spot value on the expiry date. In practice, writers of European options allow buyers to give notice prior to the expiry date that they will exercise the option. If a European option is 'exercised' prior to expiry date, the cash flows will occur on the spot value date following the original expiry date.

Sources of Options

Exchange-traded options are contracts traded through certain stock, futures or commodity exchanges. These contracts have strictly defined characteristics such as standard amounts, standard expiry dates and standard strike prices. Over-the-counter (OTC) options are options written by banks and other institutions but not traded through public exchanges. OTC options can be tailored to suit the exact needs of the option buyer. The currency options traded in the market are predominantly OTC options.

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Currency-Linked Note

A 'currency-linked note' is an instrument for which the yield is a function of the exchange rate. Many structures are possible. A popular one gives the investor a better-than-market yield provided the exchange rate remains within the specified range, but a lower-than-market yield if it moves outside that range.

If the 6-month USD interest rate is 5% per annum when spot USD/JPY is 110,000, an investor might be able to purchase a currency-linked note for which the yield will be 10% per annum, provided the USD remains within a range of 100.00 to 120.00 for the enture six months, but only 2% per annum if at any time the spot rate touches or moves above 120.00 or below 100.00.

The currency-linked note would normally be packaged by the bank as a single product. To construct it, the bank would merely sell two one-touch digitals. The future value of the premium received would be sufficient to lift the yield to 10% per annum provided another level is touched. The payout would be such that the yield is reduced to 2% per annum if either digital is exercised.

This sort of product appeals to many investors because their capital is guaranteed, and they are assured a minimum acceptable return, with the possibility of a yield which is much higher than otherwise available. The investor is effectively betting that the exchange rate will be less volatile than is being priced into the options.

Barrier Options

'Path-dependent options' are those whose payout depends on the path which the market price follows through the life of the option.

Standard calls and puts, as well as at-expiry digitals, are not path-dependent because their payout depends only on where the market price is at expiry compared with the strike price.

One-touch digital options are one example of path-dependent options. The most common group of path-depenedent options are known as barrier options. Other examples of path-dependent options include average rate or average strike options and look-back options.

'Barrier options' are options which can be knocked-out or which only kick-in if the market price reaches a specified level. There are vairations where the barrier applies for only a specified part of the life of the option. These are known as 'window' options. There are also options with multiple barriers.

'Knock-out options' have a zero payout if the barrier level is reached, even if the market price at expiry is better than the strike price. 'Knock-in options' have zero payout unless the option expires in-the-money (ie the market price at expiry is better than the strike price and at sometime during the life of the option the market price has reached the barrier level).

Hedging Options - Delta Hedging

What can a bank do to hedge the risk when it sells an option?

The risk the bank has is that if the exchange rate moves so that the option becomes more valuble, then if left unhedged, the seller has the potential to incur limitless losses. Suppose a trader sells a call option on the AUD at 0.8800 and the exchange rate goes to 0.9000. Under these circumstances, it is highly likely that the buyer will exercise his right to buy AUD at o.8800. In other words, it is highly likely that the trader will incur a 200-point loss.

Since a bank selling an option knows what the option will be valued at if the exchange rate moves ina certain direction, it is able to either buy or sell the currency in the spot market to hedge the risk. The process is known as 'delta hedging'.

Delta hedging sold options will inevitably incur losses. These losses are the debit side of selling an option. The credit side is that the seller receives an option premium from the buyer. The objective of the bank that sells an option is to lose less money in heding that it receives as a premium from the buyer. This will happen if the currency exhibits less volatility during the life of the option than was priced into the option. If the currency exhibits more volatility, then this will lead to losses from hedging that are larger than the amount received in the form of option premium.

It follows that a bank will sell and hedge an option when it believes that the future volatility of the currency will be less than the volatility entered into the Black-Scholes formula at the time of the sale. A bank will buy and hedge an option when it believes that the future volatility of the currency will be greater than the volatility input into the Black-Scholes formula at the time of the purchase.