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Currency Options & Swaps

Basics of Options
The Philadelphia Exchange commenced trading in currency options in 1982.
Currencies traded on the Philadelphia exchange:
Australian dollar, British pound, Canadian dollar, Japanese yen, Swiss franc and the Euro.

Expiration months:
March, June, September, December plus two near-term months.

Options Trading
Buyer of a call:
Assume purchase of August call option on Swiss francs with strike price of 58 ($0.5850/SF), and a premium of $0.005/SF. At all spot rates below the strike price of 58.5, the purchase of the option would choose not to exercise because it would be cheaper to purchase SF on the open market. At all spot rates above the strike price, the option purchaser would exercise the option, purchase SF at the strike price and sell them into the market netting a profit (less the option premium).

Options Trading
Writer of a call: What the holder, or buyer of an option loses, the writer gains. The maximum profit that the writer of the call option can make is limited to the premium. If the writer wrote the option naked, that is without owning the currency, the writer would now have to buy the currency at the spot and take the loss delivering at the strike price. The amount of such a loss is unlimited and increases as the underlying currency rises. Even if the writer already owns the currency, the writer will experience an opportunity loss.

Options Trading
Buyer of a Put:
The basic terms of this example are similar to those just illustrated with the call. The buyer of a put option, however, wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops (not rises as in the case of the call option). If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to the writer and receive $0.585/SF. At any exchange rate above the strike price of 58.5, the buyer of the put would not exercise the option, and would lose only the $0.05/SF premium.

The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front.

Options Trading
Seller (writer) of a put: In this case, if the spot price of francs drops below 58.5 cents per franc, the option will be exercised. Below a price of 58.5 cents per franc, the writer will lose more than the premium received for writing the option (falling below break-even). If the spot price is above $0.585/SF, the option will not be exercised and the option writer will pocket the entire premium.


Option Pricing & Valuation

An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM).
An option the would be profitable, excluding the cost of the premium, if exercised immediately is said to be in-the-money (ITM).

An option that would not be profitable, again excluding the cost of the premium, if exercised immediately is referred to as out-of-the money (OTM).

Option Pricing & Valuation

Intrinsic value
in the money at the money out of the money

max(X - ST, 0)
X ST > 0 X ST = 0 X ST < 0

max(ST - X, 0)
ST X > 0 ST X = 0 ST X < 0

Time Value

CT Int. value

PT Int. value


What are Swaps?

Swaps are contractual agreements to exchange or swap a series of cash flows.
These cash flows are most commonly the interest payments associated with debt service.
If the agreement is for one party to swap its fixed interest rate payments for the floating interest rate payments of another, it is termed an interest rate swap. If the agreement is to swap currencies of debt service obligation, it is termed a currency swap. A single swap may combine elements of both interest rate and currency swaps.

What are Swaps?

Swaps are nothing but an exchange of two payment streams. Swaps can be arranged either directly between two parties or through a third party like a bank or a financial institution. Swap market has been developing at a fast pace in the last two decades, A currency swap enables the substitution of one debt denominated in one currency at a fixed or floating rate to a debt denominated in another currency at a fixed or floating rate. It enables both parties to draw benefit from the differences of interest rates existing on segmented markets. currency swaps can be fixed-to-fixed type as well as fixedto-floating type.

What are Swaps?

Financial institutions play very important role in swap deals. Through swaps, they enable their customers who are generally enterprises to get loans and make deposits in the currency of their (i.e. customers') choice. A financial institution (FI) may act as a broker or a counterparty or an intermediary.

What are Swaps?

What are Swaps?

When an FI acts as a broker only, it is not a counterparty in the deal. It searches for counterparties and facilitates negotiations while preserving the anonymity of counterparties.


On the other hand, when an FI acts as a counterparty, it incurs various risks such as credit risk, market risk and default risk. In its role as a counterparty, Fl tries to arrange another swap having symmetrical features against another client so as to balance and reduce its own risk. For example, an FI having entered into euro-US dollar fixed-to-fixed swap with company A will try to find another company B that would like to enter into US dollar-euro fixed-to-fixed swap, involving the same amount and for the same duration.


(A) Fixed-to-fixed rate Currency Swaps: In a fixed-to-fixed swap, the two parties want to borrow at a fixed rate of interest. The swap deal enables them to get the desired currency at a favourable rate .


(B) Fixed-to-floating currency swap The steps to be followed in the fixed-to-floating rate swap are the same as in fixed to-fixed swap. Here the only difference is that one currency has fixed rate while the other has floating rate. In the case of fixed-to-fixed swap , we can bring in any intermediary to make the deal


Now, in the case of fixed-to-floating swap, if we assume that the deal is done through an intermediary financial institution. The problem with the swap deal done directly between two enterprises is that it is very time-consuming and expensive to establish. Both parties have to spend time in searching for a counterparty which needs financial resources exactly matched by the needs of the other. The search may be fruitless in the end. So the deal can be done quickly through an intermediary financial institution.

More about Swaps

The swap itself is not a source of capital, but rather an alteration of the cash flows associated with payment. What is often termed the plain vanilla swap is an agreement between two parties to exchange fixed-rate for floating-rate financial obligations. This type of swap forms the largest single financial derivative market in the world.

More about Swaps

There are two main reasons for using swaps: 1. A corporate borrower has an existing debt service obligation. Based on their interest rate predictions they want to swap to another exposure (e.g. change from paying fixed to paying floating). 2. Two borrowers can work together to get a lower combined borrowing cost by utilizing their comparative borrowing advantages in two different markets.

More about Swaps

For example, a firm with fixed-rate debt that expects interest rates to fall can change fixed-rate debt to floating-rate debt. In this case, the firm would enter into a pay floating/receive fixed interest rate swap.


The Quality Spread Differential (QSD) represents the potential gains from the swap that can be shared between the counterparties and the swap bank. There is no reason to presume that the gains will be shared equally. In the above example, Company B is less credit-worthy than Bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

Currency Swaps
The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency.

The desired currency is probably the currency in which the firms future operating revenues (inflows) will be generated.
Firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows (a significant reason for this being cost).

Currency Swaps
Example: Suppose a U.S. MNC, Company A, wants to finance a 10,000,000 expansion of a British plant.
They could borrow dollars in the U.S. where they are well known and exchange dollars for pounds. This results in exchange rate risk, OR They could borrow pounds in the international bond market, but pay a lot since they are not well known abroad.