Jones Graduate School Rice University

Masa Watanabe

INTERNATIONAL FINANCE

MGMT 657

CURRENCY OPTIONS AND OPTIONS MARKETS
Currency Options ............................................................................................ 2 Option Hedge .................................................................................................. 6 Option Profit Calculation................................................................................ 7 Currency Option Sensitivities......................................................................... 9 Put-Call Parity............................................................................................... 10 Option Delta and Delta Hedge...................................................................... 11 Practice Problems with Solutions ................................................................. 13

Call

Put

(CME hand signals)

There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can. Mark Twain

25/€ K = $1. Kd/f : Strike price id : Interest rate on currency d if : Interest rate on currency f σ : Volatility of the spot rate C : Price of a call option P : Price of a put option An option is a right and not an obligation. $Kd/f.12/€ 2 $/€ ST$/€ $1.12/€ At-the-money Out-of-the-money In-the-money $0. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS CURRENCY OPTIONS A European call option is the right to buy the underlying currency at a specified price (strike price) on a specified date in future (expiration date). the holder of a European call option exercises the option and receives the foreign currency (worth $STd/f. Std/f : Spot rate on date t. A European put option is the right to sell the underlying currency at a specified price (strike price) on a specified date in future (expiration date). PayoffT$/€ Payoff at maturity of a euro call option with strike price $1.37/€ . the spot rate at maturity) in exchange for the strike price. so the payoff to its holder is never negative. the maturity of the option is on a future date T. Notation Today is date t. At maturity. only if STd/f > Kd/f.International Finance Fall Term II. value of currency f in currency d.

an option has a premium (price) to be paid upon purchase.25/€ $0.International Finance Fall Term II. 3 .12/€ At-the-money In-the-money Out-of-the-money $0. PayoffT$/€ Payoff at maturity of a euro put option with strike price $1. An option is too good to be free—unlike a forward or futures contract. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS The holder of a European put option exercises the option and sells one unit of the foreign currency (worth $STd/f) for $Kd/f only if STd/f < Kd/f. Note: A forward “price” or a futures “price” is a contractual number and not the value of the forward or futures contract (which is zero at inception—no money changes hand).87/€ K = $1.12/€ $/€ ST$/€ A European option is exercisable only at expiration. An option has a positive value at inception (and at any time in its life). An American option is exercisable any time until expiration.

83/£. CME began trading European-style currency options also. CME GBP December 2000 call (American) Type of option Underlying asset Contract size Expiration date Exercise price Rule for exercise Premium : a call option to buy GBP : CME December GBP futures contract : £62. these options are said to be forward at-the-money (forward ATM). 4 . When the strike price of an option is equal to the forward rate.000/£ : an American option exercisable anytime until expiration : ¢6.International Finance Fall Term II.75 / contract Note: In August 2005. Forward ATM options are most liquid options.268. Most popular strike prices are those around the forward rates.500 : 3rd week of December : US$2.0683US$/£ = US$4. or £62. retrieved in the evening) Exchange Contract size Maturity Note: The underlying assets for CME currency options are CME futures contracts. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS WSJ Options Indication (WSJ online 10/30/2007.500 × .

Suppose there are 90 days until the expiration of a European euro call option and the three month $ interest rate (say LIBOR) is 1.14/€ × (1 + 0.37/€ ST$/€ 5 .22854/€ = 1.2%.02146/€ K$/€ = $1.12/€ At-the-money Out-of-the-money In-the-money $0.012×90/360) = ¢2.International Finance Fall Term II. Why do we compute FV? ProfitT$/€ Profit of the euro call option with strike price $1. Q2.12/€ $1.14/€.146 This cost should be subtracted from the payoff (see below).14146/€ FV(Premium) -$0. don’t forget to subtract the premium (cost). its future value is ¢2.37 – Strike – FV(Premium) BE $1. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS For a profit-and-loss analysis (as opposed to a payoff analysis). If the option premium is ¢2.

If the distributor can sell the wine at a higher price.International Finance Fall Term II. distributor who imports wine from France. Import Liability ProfitT $/€ Call option ProfitT $/€ ST$/€ + K$/€ -FVPrem ST$/€ Hedged position ProfitT $/€ = K$/€ -FVPrem ST$/€ -K$/€ -FVPrem The cost at expiration is at most the strike price plus the future value of the premium. Again consider a U. 6 .S. Its position can be hedged by buying € call options. it can secure a profit. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS OPTION HEDGE Example.

04×(1+.02/2) = 0.2096 -0. the put option is out of the money. The payoff from the hedged position is $1. Exercise the option. The profit of the hedged position is 1.25/€.0404$/€.30 – 0.2596M.30/€. The total profit is 1.0404 1.20/€. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS OPTION PROFIT CALCULATION Consider an exporter to Germany who has a €1 million account receivable due in 6 months.0/€ : 6 months Profit$ Hedged + Slope 1 ST$/€ 1.2596$/€.30/€. Do not 7 .0404 = 1.25 – 0.2096M. The profit of the hedged position is 1. The future value of the premium is 0.2096$/€.2596 $/€ × €1M = $1. exercise. The put option is in the money. If the terminal spot rate is $1.25 ST$/€ 1. The payoff from the hedged position is $1.25 ST$/€ Suppose the spot rate at maturity turns out to be $1.25/€ : ¢4.2096 $/€ × €1M = $1. Suppose they hedge their exposure by buying the following put option for full coverage: Export Account Receivable : €1 million A/R due : 6 months US$ interest rate : 2% Profit$ Export Profit$ Put option Strike Premium Time to maturity Long Put : $1.2096 = 1.0404 = 1.International Finance Fall Term II. The total profit is 1.

the insurance provided by the option is more valuable: Currency call option value Call option value Time value Intrinsic value Exchange rate Exchange rate distribution 8 .International Finance Fall Term II. Intuitively. Call value High volatility Low volatility Time value Intrinsic value Spot rate The higher the volatility. the higher the option value. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS Option value = Intrinsic value + Time value Intrinsic value = Value if exercised immediately Time value can be considered the value of insurance.

which is unobservable? How do you measure it? 9 .International Finance Fall Term II.) Q4. Of these six variables. Why does a call option price increase with the domestic interest rate and decrease with the foreign one? (Effects of other variables should be intuitive. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS CURRENCY OPTION SENSITIVITIES (For American options) Spot FX rate Strike price Domestic interest rate Foreign interest rate Volatility Time to expiration Call ↑ ↓ ↑ ↓ ↑ ↑ Put ↓ ↑ ↓ ↑ ↑ ↑ Q3.

PTd/f = STd/f . 10 .T f d 1+ i 1+ i 1 + id where id and if are the interest rates (prorated. Put-Call Parity at Maturity (at T) CTd/f . 2007 CURRENCY OPTIONS AND OPTIONS MARKETS PUT-CALL PARITY What happens if you buy a call option and sell short a put option with the same strike price? Long Call CallT$/ Short Put - ST$/£ + ST$/£ Long Spot ST$/ K$/£ Bond = ST $/£ − K $/£ ST$/£ This is an arbitrage condition that holds strictly in a liquid currency market. with the same strike price Kd/f. More generally at time t. respectively. respectively.International Finance Fall Term II. as usual) on currencies d and f.Kd/f where C and P are the prices of a call and a put option. European Put-Call Parity (at t) Ft d/f − K d/f S td/f K d/f d/f d/f Ct – Pt = − = .

50 spot. and negative for a put. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS OPTION DELTA AND DELTA HEDGE Option delta is the sensitivity of the option value to changes in the value of the underlying currency. Delta-hedge the option by a spot contract : you would short €0. if you want to delta-hedge your long €1 transaction (say your export position) by the call option. Why? Q7. Why? This means the following: suppose the delta of a € call option is 0. Delta-hedge the option by a futures contract: you would short about €0. In the previous picture. 11 .50. Option delta is positive for a call. and between -1 and 0 for a put.International Finance Fall Term II. Option delta is between 0 and 1 for a call. Conversely. you would short €2 of the call option. Q5. what represents the option delta? Q6.50 worth of the futures contract (because the delta of a futures contract is close to 1).

Graphically. Q5. and this makes a call (put) option buying (selling) at K more (less) valuable. and to 0 when the spot rate becomes very high (OTM). this is the first derivative of option price with respect to the spot rate. Buying and selling the foreign currency at the forward rate is a “fair” deal in that C = P for options with K = F (see the European Put-Call Parity). Q7. Q6. the slope of the call option value approaches to 0 as the spot rate decreases (OTM). 12 . Q2.International Finance Fall Term II. Contrarily. option delta is the slope of the option value diagram. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS Suggested solution to questions Q1. either by historical time series of the spot FX rate (called historical volatility) or by backing out the volatility from prices of traded options using the Black-Scholes formula (implied volatility). We will make only an intuitive argument. the slope of the put option value approaches to -1 when the spot rate decreases (ITM). F will rise by the IRP (K < F). You can measure it. It will converge to the 45 degree line as the spot rate tends to infinity (ITM). because they decrease with strike price. C ↑ (P ↓). The others are puts. Q3. Graphically. Q4. The spot rate volatility is unobservalble.e. If the domestic interest rate rises or the foreign interest rate declines. We should compute the future value because the payoff of an European option occurs at maturity. because the call option price increases with the spot rate. The first three columns represent call option prices (premiums). Option delta is positive for a call. i.. Mathematically. and vice versa. It is negative for a put for the opposite reason.

000 contracts of the dollar futures. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS PRACTICE PROBLEMS WITH SOLUTIONS Solve the following end-of-chapter problems from Butler: 6.4 The arguments are the same as for call options. So buy DKr 10. Here are the three sets of graphs: Spot exchange rate volatility and at-of-the-money put option value -3 Sd/f 0 1 2 -1 -3 Sd/f 0 3 1 2 -2 -2 13 -1 3 . The optimal hedge ratio for this delta-hedge is given by: NFut* = (amt in futures)/(amt exposed) = -β ⇒ (amt in futures) = (-β)(amt exposed) = (-1.25bn)($0. 7. which is equivalent with selling (DKr10.5 a.025)(-DKr10bn) = DKr10.25bn.80/DKr)/($50.25bn.5 a 7.000/contract) = 164.4. As the variability of end-of-period spot rates becomes more dispersed. the probability of the spot rate closing below the exercise price increases and put options gain value. 7.International Finance Fall Term II.5 Solutions 6.

International Finance Fall Term II. the increase in option value with decreases in the underlying spot rate is greater than the decrease in value from proportional increases in the spot rate. (For in-the-money puts.5 Buy an A$ call and sell an A$ put. Payoffs at expiration look like this: Payoff Long Call Payoff Short Put Payoff Synthetic Forward 0. 7.) Variability in the distribution of end-of-period spot exchange rates comes from exchange rate volatility and from time to expiration. each with an exercise price of F1$/A$ = $0. 2007 CURRENCY OPTIONS AND OPTIONS MARKETS Spot exchange rate volatility and out-of-the-money put option value -3 Sd/f -1 0 1 -3 Sd/f 0 -2 2 3 -2 -1 1 2 Spot exchange rate volatility and in-the-money put option value -3 Sd/f -1 0 1 -3 Sd/f 0 -2 2 3 -2 -1 1 2 Increasing variability in the distribution of end-of-period spot rates results in an increase in put option value in each case.75 0.75/A$ and the same expiration date as the forward contract.75 14 .75 ST$/A$ ST$/A$ 3 3 ST$/A$ + = 0.