Topic 9

Currency derivatives: Option

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1 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Learning objectives

• Describe the characteristics and use of

currency call option contracts.
• Describe the characteristics and use of
currency put option contracts.
• Apply call/put options to hedge currency risk

© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Foreign Currency Options

A foreign currency option is a contract giving the option

purchaser (the buyer) the right, but not the obligation, to buy
or sell a given amount of foreign exchange at a fixed price per
unit for a specified time period (until the maturity date).

An American option gives the buyer the right to exercise the

option at any time between the date of writing and the
expiration or maturity date.

A European option can be exercised only on its expiration date,

not before.

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 Foreign Currency Options

• The standard options that are traded on an exchange

through brokers are guaranteed, but require margin
maintenance.
• U.S. option exchanges (e.g. Chicago Board Options
Exchange) are regulated by the Securities and Exchange
Commission.
• Options on organized exchanges are standardized, but
counterparty risk is substantially reduced.

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 Foreign Currency Options

In order to obtain his right to buy/sell, the buyer of the option

contract pays a price, called the option price/ option premium
to the seller.
The size of an option contract the quantity of underlying asset
the buyer of the option wants to buy/sell.

There are two basic types of options, puts and calls.

• A call is an option to buy foreign currency
• A put is an option to sell foreign currency

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 Currency Call Options

•A currency call option grants the holder the right to

buy a specific currency at a specific price (called the
exercise or strike price) within a specific period of
time.
•A call option is
• in the money if spot rate > strike price,
• at the money if spot rate = strike price,
• out of the money if spot rate < strike price.

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 Contingency Graphs for Currency Options

For Buyer of stock Call Option For Seller of stock Call Option
Strike price = $115 Strike price = $115
Premium =$ 5 Premium = $5
Net Profit Net Profit
per Unit per Unit

Future
+$5 +$5 Spot
Rate
0 0
$110 $115 $120 $110 $115 $120
- $5 Future - $5
7 Spot
Rate

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 Currency Put Options

•A currency put option grants the holder the right to

sell a specific currency at a specific price (the strike
price) within a specific period of time.
•A put option is
• in the money if spot rate < strike price,
• at the money if spot rate = strike price,
• out of the money if spot rate > strike price.

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 Contingency Graphs for Currency Options

For Buyer of £ Put Option For Seller of £ Put Option

Strike price = $1.50 Strike price = $1.50
Premium = $ .03 Premium = $ .03
Net Profit Net Profit
per Unit per Unit
+$.04 +$.04
Future
+$.02 Spot +$.02
Rate
0 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- $.02 - $.02 Future
Spot
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- $.04 - $.04 Rate