Currency options

Call option – gives the buyer of the option the right to buy the underlying asset
at a specified rate (strike price) on a given date
Put option – gives the buyer of the option the right to sell the underlying asset
at a specified rate (strike price) on a given date

• exercise/strike price
• buyer of the option is taking the long position
• seller of the option is also called the writer; seller takes the short position
• option premium is the cost

European style – an option that cannot be exercised before the expiration date
American style – can be exercised before the expiration date

Call option example

You are buying a call option that is giving you the right to purchase British pound at $1.50 after 3
months; The option premium = $0.05
Contract size: £100,000 in a contract
The premium (in an European option) is like a sunk cost

After 3 months – the market price (i.e. the spot rate) is $1.60 –
Does it make sense?
Market price is $1.60
Option contract price (strike/ exercise) is $1.50
The call option will be exercised
S = Spot rate at expiration
X = Strike price
P= Premium
S = 1.60; X = 1.50; P = 0.05

Net Profit (per unit) for the buyer of the option = (S-X) -P= ($1.60 – $1.50) - $.05 =$.10 - $.05 =
+$0.05
total profit = $.05*100,000 = $5000
the gross profit is $0.10, but the net profit is ($0.10 - $0.05) = $0.05
After 3 months – the market price (i.e. the spot rate) is $1.40 – the net loss is equal to the premium;
the call option WILL NOT BE EXERCISED

At $1.53, if the buyer exercises the option, she gets $0.03 - $0.05 = - $0.02 Loss is reduced by $0.03
from the maximum amount. The option, therefore, will be exercised at $1.53. In fact, at any rate
greater than $1.50, the option will be exercised.
Net Profit (per unit) for the buyer of the option = (S-X) -P= (1.53 – 1.50) =$.03 - $.05 = - $0.02

Put option example

You are purchasing a put option that is giving you the right to sell British pound at $1.50 after 3
months.

The option premium = $0.03

After 3 months – if the market price (i.e. the spot rate) is $1.60 – the option will not be exercised
After 3 months – if the market price (i.e. the spot rate) is $1.40 - the option will be exercised
S = Spot rate at expiration
X = Strike price
P= Premium
S = 1.40; X = 1.50; P = 0.03
Net profit for the buyer of the put option @ $1.40
(X – S) – P = ($1.50 – $1.40) - $.03 = $.07
@ $1.48, if the buyer exercises the put option, she gets $0.02 - $0.03 = - $0.01 Loss is reduced by
$0.02. The option, therefore, will be exercised at $1.48. In fact, at any rate below $1.50, the
option will be exercised by the buyer.

Net profit for the put option @ $1.48 = (X – S) – P = ($1.50 – $1.48) - $.03 = -$0.01
Q1: A call option on Canadian dollars with a strike price of $.60 is purchased by a speculator for a
premium of $.06 per unit. The option will be expired after 3 months. Assume there are 50,000 units in
this option contract. If the Canadian dollar’s spot rate is $.65 at the time the option is exercised, what
is the net profit per unit and for one contract to the speculator? What would the spot rate need to be at
the time the option is exercised for the speculator to break even?

• The buyer of the call option can purchase CAD 1 at $.60 by exercising it
• Premium is the COST, paid by the buyer and received by the seller of the option
• Premium = $.06
• The buyer is starting with a loss of $.06

Right to buy CAD at $.60 and the market rate or spot rate (S) is $.65

A CALL option is exercised if the spot rate at expiration is greater than strike/exercise price

• S = Spot rate at expiration; X = Strike price or exercise price; P= Premium

• Maximum loss = P = - $.06
• Net profit per unit to the call buyer = (S-X) -P = ($.65 - $.60) - $.06 = -$.01
• Total profit = -$.01*50,000 = -$500

• Per unit net profit if the future spot S= $0.66:

• Net profit per unit = (S – X) – P = (0.66 -0.60) – 0.06 = $0.00

• $.66 is the break-even spot rate at expiration

Q2: A put option on Australian dollars with a strike price of $.80 is purchased by a speculator for a
premium of $.02. If the Australian dollar’s spot rate is $.74 on the expiration date, should the
speculator exercise the option on this date or let the option expire? What is the net profit per unit to
the speculator? Also calculate the break-even spot rate at expiration.

• The buyer is getting the right to sell AUD 1 at $.80

• It’s a put option on Australian dollars, i.e. the speculator can sell Canadian dollar to the seller
of the put at $0.80.
• The speculator (buyer of the put) paid a premium of $0.02.
• When S < X, the put option will be exercised

S = Spot rate at expiration; X = Strike price or exercise price; P= Premium

Strike price X = $.80; Premium = $.02; S = $.74
Net profit per unit = (X – S) – P = (0.80 -0.74) -$.02 = $.04

@ $.78 the put buyer is breaking even

Net profit per unit = (X – S) – P = (0.80 -0.78) – 0.02 = $ 0.00