INTRODUCTION

A currency option is no different from a stock option

except that the underlying asset is foreign
exchange. The basic premises remain the same: the
buyer of option has the right but no obligation
to enter into a contract with the seller. Therefore the
buyer of a currency option has the right, to his
advantage, to enter into the specified contract
TERMINOLOGY OF CURRENCY OPTIONS
• Call Option:- A call option will have intrinsic
value only when the spot price is above the strike price.
• Put Option:- A put option will have
intrinsic value only when the spot price is below the strike
price.
• Intrinsic Value Of The Option:- Intrinsic
value is simply the difference between the spot price and the
strike price.
• Time Value Of The Option:- When the price of a call or put
option is greater than its intrinsic value, it is because of its
time value.
• Strike Price/ Exercise Price:- The price at which a
specific derivative contract can be exercised. Strike prices
is mostly used to describe stock and index options, in
which strike prices are fixed in the contract. For call
options, the strike price is where the security can be
bought (up to the expiration date), while for put options
the strike price is the price at which shares can be sold.
• Maturity / Expiry Date:- The date on which an
option expires and after that date the option can not
be exercised.
• American Option:- An option that can be exercised
anytime during its life.
• European Option:- An option that can only be
exercised only after maturity.
 Hedging
Hedging means reducing or controlling risk. This is done by
taking a position in the futures market that is opposite to the
one in the physical market with the objective of reducing or
limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash

position due to changes in price levels will be countered by
changes in the value of a futures position. For instance, a wheat
farmer can sell wheat futures to protect the value of his crop
prior to harvest. If there is a fall in price, the loss in the cash
market position will be countered by a gain in futures position
 Valuation Of Options
Because the values of option contracts depend on a
number of different variables in addition to the value of the
underlying asset, they are complex to value. There are
many pricing models in use, although all essentially
incorporate the concepts of rational pricing, Moneyness,
Option time value and Put-call parity
 Determinants Of Valuation Of Currency
Option
• The Spot Exchange Rate.
• The Strike Or Exercise Price.
• Time To Maturity.
• Home Currency Risk Free Interest Rate.
• Foreign Currency Risk Free Interest Rate.
• Volatility Of The Spot Exchange Rate.