Currency Options

Currency options trade on the

Philadelphia Exchange (PHLX)
There also exists a very active over-
the-counter (OTC) market
Currency options are used by
corporations to buy insurance when
they have an FX exposure
Currency option- Exporter
perspcetive
A US exporter, exporting to Australia,
expects to receive 10 Mn AUD in 3 months
time.
The 3m Forward rate is 0.700 USD/AUD.
The exporter buys a 3 month put option on
AUD, with K =0.7000.
After 3 months, if exchange rate is
A) 0.67000 USD/AUD.
B) 0.73000 USD/AUD.
Gain/Loss to exporter on option contract

Currency option- Importer perspective
A US importer, importing from European
manufacturer and is expected to pay 1Mn
Euro for imported cargo, arriving in 3
months time.
 The 3m Forward rate is 1.200 USD/Euro.
The exporter buys a 3 month call option on
Euro, with K =1.200
After 3 months, if exchange rate is
A) 1.2500 USD/EUR
B) 1.1500 USD/EUR
Gain/Loss to importer on option contract
Range Forward Contracts
 Here on option is bought and another option
sold, such that the price of the bought option
equals the price of the sold option. (Buying a
call option with strike price K1 and selling a put
option with strike price K2).
 A US Exporter buying a put option on Euro with
strike price K1 = 1.8500USD/EUR and selling a
call option with strike price K2= 1.9500
USD/EUR.
 The current 3 month forward rate is
1.9200USD/EUR.

Have the effect of creating a costless
hedging structure.
Ensures that the exchange rate paid or
received will lie within a certain range.
When currency is to be received it involves
buying a put with strike K1 and selling a call
with strike K2
When currency is to be paid it involves
selling a put with strike K1 and buying a call
with strike K2 (with K2 > K1)
Range Forward Contract

Payoff
Payoff

Asset
Price
K1 K2 K1 K2 Asset
Price

Short Long
Position Position
Exotic options
These are basically structured options,
used for specific purpose.
1)Asian options
2) Barrier options
3) Basket options
4) Swing Options
Volatility
Volatility
is the uncertainity about the returns
provided by underlying asset.
The volatility is the standard deviation of the
continuously compounded rate of return in 1
year.
The standard deviation of the return in time Dt
is  t

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Estimating Volatility from Historical
Data
1. Take observations S1, . . . , Sn on the
variable at end of each trading day
2. Define daily return as:
 Si 
ui  ln  
 S i1 

Calculate the standard deviation, s , of

the ui ´s
The historical volatility per year estimate
 252
sis:

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 Market Implied volatility
The volatility implied from market prices of
options are called implied volatility.
The implied volatility of an option is the volatility
for which the Black-Scholes price equals the
market price
It measures, the market expectation of the future
volatility of the underlying.
Implied price distribution are different than Log
normal distribution.

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The Volatility Smile

Implied
Volatility

Strike
Price

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Volatility Term Structure
The volatility term structure tend to be
downward sloping when volatility is high
and upward sloping when it is low

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Volatility Surface
It
combines volatility term structure and volatility
smile in a matrix form.

The columns reflect volatility term structure &

rows reflect volatility smile, across different
strike rates.

This volatility matrix is used by traders for

valuing options with different strike prices and
maturity.

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Example of a Volatility Surface

S trik e P ric e

0 .9 0 0 .9 5 1 .0 0 1 .0 5 1 .1 0

1 m n th 1 4 .2 1 3 .0 1 2 .0 1 3 .1 1 4 .5

3 m n th 1 4 .0 1 3 .0 1 2 .0 1 3 .1 1 4 .2

6 m n th 1 4 .1 1 3 .3 1 2 .5 1 3 .4 1 4 .3

1 ye a r 1 4 .7 1 4 .0 1 3 .5 1 4 .0 1 4 .8

2 ye a r 1 5 .0 1 4 .4 1 4 .0 1 4 .5 1 5 .1

5 ye a r 1 4 .8 1 4 .6 1 4 .4 1 4 .7 1 5 .0

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