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P G Apte

1

Introduction

• An option is a contract in which the buyer of

the option has the right to buy or sell a

specified quantity of an asset, at a pre-specified

price, on or upto a specified date if he chooses

to do so; however, there is no obligation for him

to do so

• Options are available on a large variety of

underlying assets including common stock,

currencies, debt instruments, and commodities.

• Options are also available on financial prices

such as interest rates

2

Options on Spot, Options of Futures

and Futures Style Options

• Option on spot currency: Right to buy or sell

the underlying currency at a specified price; no

obligation

• Option on currency futures: right to establish a

long or a short position in a currency futures

contract at a specified price; no obligation

• Futures-style options: Represent a bet on the

price of an option on spot foreign exchange.

Margin payments and mark-to-market as in

futures.

3

Options Terminology

• The two parties to an option contract are the

option buyer and the option seller also called

option writer

• Call Option: A call option gives the option

buyer the right to purchase a currency Y

against a currency X at a stated price Y/X, on

or before a stated date.

• Put Option: A put option gives the option buyer

the right to sell a currency Y against a currency

X at a specified price on or before a specified

date

4

Options Terminology (contd.)

• Strike Price (also called Exercise Price) The

price specified in the option contract at which

the option buyer can purchase the currency

(call) or sell the currency (put) Y against X.

Maturity Date: The date on which the option

contract expires. Exchange traded options have

standardized maturity dates.

• American Option: An option, that can be

exercised by the buyer on any business day

from trade date to expiry date.

• European Option: An option that can be

exercised only on the expiry date

5

Options Terminology

• Option Premium (Option Price, Option Value):

The fee that the option buyer must pay the

option writer “up-front”. Non-refundable.

• Intrinsic Value of the Option: The intrinsic

value of an option is the gain to the holder on

immediate exercise. Strictly applies only to

American options.

• Time Value of the Option: The difference

between the value of an option at any time and

its intrinsic value at that time is called the time

value of the option.

6

Options Terminology

• A call option is said to be at-the-money if

Current Spot Price (St ) = Strike Price (X),

• in-the-money if St > X and out-of-the-money if

St < X

• A put option is said to be at-the-money if

• St = X, in-the-money if St < X and out-of-the-

money if St > X

• In the money options have positive intrinsic

value; at-the-money and out-of-the money

options have zero intrinsic value.

7

Price Quotations

• Option Price Quotations (exchange traded)

GBP/USD GBP 31250 (cents per pound)

Strike Price CALLS PUTS

Sep Oct Nov Sep Oct Nov

1.500 1.61 2.27 2.72 1.19 1.74 2.18

1.510 1.16 1.77 2.26 1.70 2.24 2.63

8

Elementary Option Strategies

• Assumptions

– Ignore brokerage commissions, margins etc

– Dealing with European options

– All exchange rates, strike prices, and

premiums will be in terms of home currency

per unit of some currency A and the option

will be assumed to be on one unit of the

currency A

– Profit profiles shown at maturity

9

Elementary Option Strategies

• Call Options

– Current spot rate, St

– Strike price X

– Call option premium c

– Spot rate at maturity ST

– Call Option Buyer’s Profit = -c for ST ≤ X

= ST - X - c for ST > X

– Call Option Writer’s Profit = +c for ST ≤ X

= -(ST - X - c)

for ST > X

10

Elementary Option Strategies

X

0

c S(T)

(-) X+c

Option Buyer

Option Seller

11

Elementary Option Strategies

• Put Options : Premium p

– Put Option Buyer's Profit

– = -p for ST ≥ X

= X - ST – p for ST < X

– Put Option Writer’s Profit

– = +p for ST ≥ X

= -(X - ST - p) for ST < X

12

Elementary Option Strategies

Option Buyer

Option Writer

+

0

X-p X

13

Elementary Option Strategies

• Spread Strategies

– Bullish Call Spread: Consists of selling the call with the

higher strike price and buying the call with the lower

strike price

– Bearish Call spread: If the investor expects the foreign

currency to depreciate, he can adopt the reverse

strategy viz. buy the higher strike call and sell the

lower strike call

– Bullish Put Spread: Consists of selling puts with higher

strike and buying puts with lower strike

– Bearish Put Spread: Opposite of Bullish Put Spread

– These strategies, involving options with same maturity

but different strike prices are called vertical or price

spreads

14

Bull Spread Using Calls

Buy Call Strike X1, Premium c1;

Sell Call Strike X2, Premium c2 ;

Profit

c2

ST

X1 X2

c1

15

Bull Spread Using Puts

Buy Put Strike X1, Premium p1; Sell Put Strike X2,

Premium p2

Profit

p2

X1 X2 ST

p1

16

Bear Spread Using Calls

Profi

t

X1 X2 ST

17

Bear Spread Using Puts

Profit

X1 X2 ST

18

Elementary Option Strategies

• Butterfly Spreads – Short Butterfly

The CHF/USD spot is 0.62 Calls on CHF with

strikes 0.58, 0.62 and 0.66 USD per CHF are

trading at premiums of $0.05, $0.02 and $0.01.

– A butterfly spread is sold by writing two calls

with the middle strike price of 0.62, and buying

one call each with strike prices on either side,

here, 0.58 and 0.66

Market view: Drop in volatility; market

expected to make very small moves.

19

Butterfly Spread Using Calls

Payoff Profile of a Short Butterfly

Long Calls Strike X1 and X3; Short Two Calls Strike X2

Profit

X1 X2 X3 ST

20

Elementary Option Strategies

• European calls on CHF are available with strikes

0.58, 0.62, 0.66 USD per CHF

– A butterfly spread is bought by buying two

calls with the middle strike price of 0.62, and

writing one call each with strike prices on either

side, here, 0.58 and 0.66

– Market View

21

Elementary Option Strategies

– Horizontal spreads consist of simultaneous

purchase and sale of two options identical in all

respects except the expiry date

– The difference in premiums between the two

options will be moderate at the time of

initiation but will have widened at the time of

expiry of the short term option provided the

underlying exchange rate has not moved

drastically

22

Elementary Option Strategies

• Straddles and Strangles

– A long straddle consists of buying a call and

a put both with identical strikes and

maturity. Usually both are at-the-money.

– A long strangle consists of buying an out-of-

the- money call and an out-of-the-money put

– Both are bets that the underlying price is

going to make a strong move up or down I.e.

market is going to be more volatile.

23

A Straddle Combination

X: Strike in Put and Call

c,p: Call, Put Premiums

Profit

X ST

X-p-c X+p+c

24

A Strangle Combination

X1: Put Strike X2: Call Strike

c: Call Premium p: Put Premium

Profit

X1 X2

ST

X1-p-c X2+p+c

25

Hedging with Currency Options

– Hedge a Foreign Currency Payable with a

Call.

– Hedge a Receivable with a Put Option

– Covered Call Writing. Earn a premium by

writing a call against a receivable.

– Options are a convenient hedge for

contingent liabilities (Note however that the

risk of the liability materialising or not

cannot be hedged with the option)

– Options allow hedger to bet on favorable

currency movements with limited downside

risk.

26

Principles of Option Pricing

• Notation

– t : The current time

– T : Number of days from t to expiry of the option i.e.

the option expires at time t+T

– C(t) : Value measured in HC, at time t, of an

American call option on one unit of spot foreign

currency

– P(t) : Value in HC, at time t, of an American put

option on one unit of foreign currency

– c(t), p(t) : Values of European call and put options

in HC

– Exchange rates, strike prices stated as units of HC

(home currency) per unit of FC (foreign currency)

27

Principles of Option Pricing

Notation

– S(t) : The spot exchange rate at time t. S(t+T) is thus

the spot rate at option maturity. The spot rate is in

terms of units of HC per unit of FC

– X : The exercise or strike price, units of HC per unit

of FC

– iH : Domestic risk-free, continuously compounded

annual money market interest rate. It is assumed to

be constant

– iF : Foreign risk-free, continuously compounded

annual money market interest rate, assumed to be

constant

28

Principles of Option Pricing

– BH(t,T) : Home currency price, at time t, of a pure

discount bond that pays one unit of home currency

at time t+T with continuous compounding

H

– BF(t,T) : Foreign currency price, at time t, of a pure

discount bond that pays one unit of foreign currency

at time t+T, with continuous compounding

B = e-iF (T/360)

F

29

Principles of Option Pricing

• Determinants of option values

S,X,T,iH,iF,σ

• Basic principles of option valuation

– Option values can never be negative. At any time t,

c(t), C(t), p(t), P(t) ≥ 0

– ct, Ct ≤ St and pt, Pt ≤ X

– On exercise date, the option value must equal the

greater of zero and the intrinsic value of the option

c(t+T), C(t+T) = max [0, S(t+T)-X]

p(t+T), P(t+T) = max [0, X-S(t+T)]

At any time t < T

- C(t) ≥ max [c(t), S(t)-X] ; P(t) ≥ max [p(t), X-S(t)]

30

Principles of Option Pricing

– Consider two American options, calls or puts, which

are identical in all respects except time to maturity.

One matures at t+T1 while the other at t+T2 with

T2 > T1. Let C1, C2 and P1, P2 denote the premiums.

Then

C2(t) ≥ C1(t) P2(t) ≥ P1(t) for all t ≤ T1

∂C/∂T ≥ 0 ∂P/∂T ≥ 0

Two options differing only in exercise price

C(X2, t) < C(X1, t); c(X2, t) < c(X1, t)

P(X2, t) > P(X1, t); p(X2, t) > p(X1, t))

where X1 and X2 are strike prices with X2 > X1

∂C/∂X , ∂c/∂X < 0 ∂P/∂X , ∂p/∂X > 0

31

Principles of Option Pricing

– At any time t we must have

c(S,X,T) + XBH(t,T) ≥ S(t)BF(t,T) or,

c(S,X,T) ≥ S(t)BF(t,T) - XBH(t,T)

and therefore

C[S(t),X,t,T] ≥ c[S(t),X,t,T]

≥ S(t)BF(t,T) - XBH(t,T)

C[S(t),X,t,T]

≥ max{[S(t) - X], [S(t)BF(t,T) - XBH(t,T)]}

32

Principles of Option Pricing

– For European and American put options we

have

p[S(t),X,t,T] ≥ XBH(t,T) - SBF(t,T)

P[S(t),X,t,T]

≥ max {[X-S(t)], [XBH(t,T)-SBF(t,T)]}

Since SBF/BH = Ft,T = T-day Forward Rate at t

C[S(t),X,t,T] ≥ c[S(t),X,t,T] ≥ BH(t,T)(Ft,T-X)

P[S(t),X,t,T] ≥ p[S(t),X,t,T] ≥ BH(t,T)(X – Ft,T)

33

Principles of Option Pricing

– Put-Call Parity Relationship for European Options

p[S(t),X,t,T] = c[S(t),X,t,T]+XBH(t,T)-S(t)BF(t,T)

p[S(t),X,t,T] = c[S(t),X,t,T]+BH(t,T)(X-Ft,T)

= Long HC bond

34

35

36

Option Pricing Models

• The central idea in all the models is risk neutral

valuation

• The theoretical models typically assume

frictionless markets i.e. no transaction costs, taxes,

no restrictions on short selling, continuous trading

etc.

• A portfolio can be constructed of traded assets

which replicates option payoff

• Value of the option must be equal to value of the

portfolio irrespective of investor’s risk-return

preferences

37

Option Pricing Models

• European Call Option Formula (Black-Scholes)

c(t) = S(t)BF(t,T)N(d1) - XBH(t,T)N(d2)

ln(SBF/XBH) + (σ 2/2)T

d1 = --------------------------------

σ√T d

N(d) = ∫ (

1

) e(-z2 / 2) dz

-∞ 2ππ

ln(SBF/XBH) - (σ 2/2)T

d2 = --------------------------------

σ√T

σ in the above formula denotes the standard deviation

of log-changes in the spot rate 38

Option Pricing Models

c(t) = BH(t,T) [Ft,TN(d1) - XN(d2)]

ln(Ft,T/X) + (σ 2/2)T

d1 = ----------------------------

σ√T

ln(Ft,T/X) - (σ 2/2)T

d2 = ----------------------------

σ√T

39

Option Pricing Models

p(t) = XBH(t,T)N(D1) - S(t)BF(t,T)N(D2)

and D2 = -d1

40

Option Deltas and Related Concepts:

The Greeks

• The Delta of an option

∆ = ∂c/∂S for a European call option

= ∂p/∂S for a European put option

• Having taken a position in a European option,

long or short, what position in the underlying

currency will produce a portfolio whose value is

invariant with respect to small changes in the spot

rate? A delta-neutral position is unaffected by

small changes in the underlying spot rate

41

Option Deltas and Related Concepts:

The Greeks

• The Elasticity of an option is defined as the

ratio of the proportionate change in its value

to the proportionate change in the

underlying spot rate. For a European call,

elasticity would be [(∂c/c)/(∂S/S)]

• The Gamma of an option

Γ = ∂2c/∂S2 for a European call

Γ = BFN′(d1)/Sσ√T

42

Option Deltas and Related Concepts:

The Greeks

• A hedge which is delta neutral as well as

gamma neutral will provide protection

against larger movements in the spot rate

between readjustments

• The Theta of an Option

Θ = ∂c/∂t for a European call

Θ = ∂p/∂t for a European put

43

Option Deltas and Related Concepts:

The Greeks

• The Lambda or Vega of an Option

– Rate of change of its value with respect to the

volatility of the underlying asset price

• Concept of implied volatility

– Compute the value of σ which, when input into

the model, will yield a model option value

equal to the observed market price

• Volatility smile depicted in figure below

44

Option Deltas and Related Concepts:

The Greeks

Volatility Smile

45

Over-The-Counter (OTC) Market

Practices

• Like in the forex market, dealers trade

directly with each other and through

brokers

• Unless a quote for a specific option - call or

put - is requested, the market practice is to

quote a two way-price in terms of implied

volatility for an At-the-Money- Forward

(ATMF) straddle for a given period

46

Futures Options

contract

• A call option on a futures contract, if exercised,

entitles the holder to receive a long position in the

underlying futures contract plus a cash amount

equal to the price of the contract at that time minus

the exercise price

• A put option on being exercised gives the holder a

short position in the futures contract plus cash

equal to the exercise price minus the futures price

47

Innovations with Embedded Options

Option)

• Participating Forwards

• Conditional Forward (Forward Reversing Option)

• Barrier Options

– Up-and-Out or Knock-out Put Option

– Up-and-In Put Option

– Down-and-Out Call Option

– Down-and-In Call Option

48

Range Forwards

Price Paid

F2

F1

F1 F2 ST

49

Participating Forward

Consider first the sale of a participating forward. The seller is

assured a minimum price F1 which is less than the current

outright forward rate for the same maturity. If at maturity, the

spot rate, ST, is greater than F1, the seller gets a price of [F1 + µ

(ST - F1)], where µ is a positive fraction, 0 < µ < 1. If ST < F1, the

seller gets F1.

Suppose a customer is not willing to pay more than CHF 1.7500

for a dollar. He buys a conditional forward in which the seller

quotes a premium which is to be paid if and only if the price of a

dollar plus the premium is less than 1.7500.

50

Barrier Options

Up-and-Out or Knock-out Put Option

Consider a European put option on GBP against USD at a

strike price of USD 1.80 per GBP. If we build into it an additional

condition that the option ceases to exist or is "knocked out" if the

spot GBP/USD goes above 2.00 at any time during the life of the

option irrespective of what the spot rate is on the expiry date, it

becomes a Up-and-Out put or a Knock-out put. An American firm

with a GBP receivable might buy such an option to protect the

dollar value of its asset with some side arrangement with the bank

that the moment the spot goes above 2.00, a forward sale contract

will come into effect. The advantage of this option is its lower up-

front premium compared to a standard European put.

51

Barrier Options

Up- and-In Put Option

In the above example, a put with a strike of USD 1.80

and a condition that the put becomes effective only if the

spot rate goes above 2.00 makes it a up- and-in put. If the

outlook for GBP is bullish in the short to medium run but

bearish in the long run a hedger or trader might use such an

option; alternatively he could buy short-maturity calls and

longer-maturity puts. The up-and-in put is a cheaper

alternative.

52

Barrier Options

• Down-and-Out Call Option

A German firm with USD payable might buy a call on USD with

a strike price of DEM 1.60 per USD with a knock-out at 1.55. It

might have an arrangement to buy USD forward the moment the

dollar moves below 1.55. This call would be cheaper than a

standard call with the same strike and maturity.

Down-and-In Call Option

T This opposite of a down-and-out call. The down-and-in call

comes into existence only if the spot rate moves below the barrier

level. This option will be used when the view is bearish in the

short run but bullish in the long run.

53

Innovations with Embedded Options

• Contingent Options and Compound Options

• Conditional Forward Contracts

• Exotic options

– Preference Options – Decide call or put later

– Asian Options

– Look-back Options: Payoff based on most favourable

rate during option life.

– Average Rate Option: Payoff based on average value of

the underlying exchange rate during option life

– Bermudan Options : exercise at discrete points of time

during option life. Sort of compromise between

American and European options.

54

Empirical Studies of Option Pricing

Models

• There is substantial evidence of pricing

biases in case of the Black-Scholes as well

as alternative models

• Recent research has focussed on relaxing

some of the restrictive assumptions of the

Black-Scholes model

55

Currency Options in India

and foreign currencies are as yet not

available in the Indian market

• Since January 1994, the RBI has however

permitted Indian banks to write "cross-

currency" options including barrier options

and other innovations.

56

Summary

benefit from favorable movements in the

spot rate while at the same time limiting his

loss in case of adverse movements

• They can be combined in several ways to

create financial engineering products with

unique payoff profiles

57

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