CHAPTER

SEVEND

FOREIGN CURRENCY
OPTIONS

1
 CHAPTER OVERVIEW

• Introduction
• Contract specifications
• Option positions
• Hedging using option contract
• Strategy on currencies option
• Option pricing

2
FOREIGN CURRENCY OPTIONS

• A foreign currency option is a contract giving the purchaser

of the option the right to buy or sell a given amount of
currency at a fixed price per unit for a specified time period
– The most important part of clause is the “right, but not the
obligation” to take an action
– Two basic types of options, calls and puts
• Call – buyer has right to purchase currency
• Put – buyer has right to sell currency
– The buyer of the option is the holder and the seller of the option is
termed the writer

3
FOREIGN CURRENCY OPTIONS MARKETS
 Table shows option prices on British pound taken from the online edition of
Wall Street Journal on Friday, January 31, 2007

BRITISH POUND (CME)

62,500 pounds; cents per pound
Strike Calls Puts
Price Feb Mar Apr Feb Mar Apr
162 2.36 2.94 - 0.16 0.74 -
163 1.5 2.32 2.14 0.3 1.12 2.02
164 0.86 1.7 - 0.66 1.5 -
165 0.5 1.36 1.34 - 2.16 -
166 0.26 1.02 1 - - -
167 0.12 0.76 0.92 - - -

4
11/23/22 5
 FOREIGN CURRENCY OPTIONS

• Every option has three different price elements

– The strike or exercise price is the exchange rate at which the foreign
currency can be purchased or sold
– The premium, the cost, price or value of the option itself paid at time
option is purchased
– Spot exchange rate in the market

6
 FOREIGN CURRENCY OPTIONS

• Options may also be classified as per their payouts

– At-the-money (ATM) options have an exercise price equal to the
spot rate of the underlying currency
– In-the-money (ITM) options may be profitable, excluding
premium costs, if exercised immediately
– Out-of-the-money (OTM) options would not be profitable,
excluding the premium costs, if exercised

7
 FOREIGN CURRENCY OPTIONS MARKETS

• Over-the-Counter (OTC) Market – OTC options are most frequently

written by banks for US dollars against British pounds, Swiss francs,
Japanese yen, Canadian dollars and the euro
– Main advantage is that they are tailored to purchaser
– Counterparty risk exists
– Mostly used by individuals and banks
• Organized Exchanges – similar to the futures market, currency options are
traded on an organized exchange floor
– The Chicago Mercantile and the Philadelphia Stock Exchange serve options
markets
– Clearinghouse services are provided by the Options Clearinghouse Corporation
(OCC)

8
 OPTION POSITIONS
There are four types of options positions: #
• A long position in a call option
• A long position in a put option
• A short position in a call option
• A short position in a put option
The underlying assets
• Commodities
• Stock
• Foreign currency
• Index
• Futures…

9
 PROFIT & LOSS FOR THE BUYER OF A CALL OPTION

“At the money”

Profit
Strike price
(US cents/£)
“Out of the money” “In the money”
+ 10

+5
Unlimited profit

0 Spot price
160 165 170 175 180 (US cents/£)
Limited loss
-5
Break-even price
- 10

Loss

The buyer of a call option on £, with a strike price of 170 cents/£, has a limited loss of 50 cents/£ at
spot rates less than 170 (“out of the money”), and an unlimited profit potential at spot rates above 170
cents/£ (“in the money”). 10
PROFIT & LOSS FOR THE WRITER OF A CALL OPTION

Profit
(US cents/£) Strike price

+ 10

+5 Break-even price
Limited profit

0 Spot price
160 165 170 175 180 (US cents/£)
-5 Unlimited loss

- 10

Loss

The writer of a call option on £, with a strike price of 170cents/£, has a limited profit of 5 cents/£ at
spot rates less than 170, and an unlimited loss potential at spot rates above (to the right of) 175
cents/SF. 11
PROFIT & LOSS FOR THE BUYER OF A PUT OPTION

“At the money”

Profit
Strike price
(US cents/£)
“In the money” “Out of the money”
+ 10

+5 Profit up
To 165
0 Spot price
160 165 170 175 180 (US cents/£)
Limited loss
-5
Break-even
price
- 10

Loss

The buyer of a put option on £, with a strike price of 170cents/£, has a limited loss of
5 cents/£ at spot rates greater than 170 (“out of the money”), and a profit
potential at spot rates less than 170cents/£ (“in the money”) up to 165 cents. 12
PROFIT & LOSS FOR THE WRITER OF A CALL OPTION

Profit
(US cents/£) Strike price

+ 10
Break-even
+5 price
Limited profit
0 Spot price
160 165 170 175 180 (US cents/£)
-5

Loss up
- 10 To 165

Loss
The writer of a put option on £, with a strike price of 170 cents/£ has a limited profit of
5 cents/£ at spot rates greater than 165 and a loss potential at spot rates
less than 165 cents/£.
13
11/23/22 14
 OPTION POSITIONS
There are four types of options positions: #
• A long position in a call option: MUA QUYỀN CHỌN MUA: ĐẦU
TƯ GIÁ TĂNG MẠNH: thực hiện khi S(t)>E, không thực hiện khi
S(t)<E
• A long position in a put option: MUA QUYỀN CHỌN BÁN: ĐẦU TƯ
GIÁ GIẢM MẠNH: thực hiện khi S(t)<E, không thực hiện khi S(t)>E
• A short position in a call option: BÁN QUYỀN CHỌN MUA: ĐẦU
TƯ GIÁ GIẢM NHẸ HOẶC KHÔNG TĂNG KHÔNG GIẢM
QUANH VÙNG GIÁ THỰC HIỆN:thực hiện khi S(t)>E, không thực
hiện khi S(t)<E
• A short position in a put option: BÁN QUYỀN CHỌN BÁN: ĐẦU TƯ
GIÁ TĂNG NHẸ HOẶC KHÔNG TĂNG KHÔNG GIẢM QUANH
VÙNG GIÁ THỰC HIỆN: thực hiện khi S(t)<E, không thực hiện khi
S(t)>E

15
 STRATEGIES INVOLVING A SINGLE
OPTION AND A STOCK

 Profit patterns. Profit

 (a) Long position in a

stock combined with
short position in a call, x
x
ST ST
 (b) Short position in a
stock combined with
long position in a call.
(a) (b)
 (c) Long position in a
Profit Profit
put combined with
long position in a
stock,
 (d) Short position in a x
x
put combined with ST ST

stock position in a
stock
(c) (d)
16
B1. BULL SPREAD CREATED USING CALL OPTION-
Buying a call on a stock with a certain price and selling a call on the same stock with a higher
price

This strategy limits

the investor’s
Profit
upside potential as
well as downside
risk

X1 X2 ST

17
B1. BULL SPREAD CREATED USING CALL OPTION-
Buying a call on a stock with a certain price and selling a call on the same stock with a higher
price

Forcasting: S(t) >

[E1 - (K2 - K1)]:
Profit
using bull spread-
call option

X1 X2 ST

18
B2. BULL SPREAD CREATED USING PUT OPTION Buying a
put on a stock with a certain price and selling a put on the same stock with a higher price

Profit

X1 X2 ST

19
B3. BEAR SPREAD CREATED USING CALL OPTION
Buying a call AT a strike price and selling a call with a LOWER strike price

This strategy limits

Profit the investor’s
upside potential as
well as downside
risk

X1 X2 ST

20
B4. BEAR SPREAD CREATED USING PUT OPTION-
Buying a put at a strike price and selling a put with a lower strike price

Profit

X1 X2 ST

21
B5. BUTTERFLY SPREAD CREATED USING CALL
OPTIONS- Buying one call at low price X and buying another call at high strike price X
1 3
and selling two call with a strike price X 2, halfway between X1 & X3

Profit
This strategy refer to
an investment who
fells that large stock
price moves are
unlikely

X1 X2 X3
ST

22
BASIC OPTION PRICING RELATIONSHIPS AT EXPIRY

• At expiry, an American option is worth the same as a

European option with the same characteristics.
• If the call is in-the-money, it is worth ST – E.
• If the call is out-of-the-money, it is worthless.
CaT = CeT = Max[ST – E, 0]
• If the put is in-the-money, it is worth E – ST.
• If the put is out-of-the-money, it is worthless.
PaT = PeT = Max[E – ST, 0]

Copyright © 2014 by the McGraw-Hill Companies,

Inc. All rights reserved.
 MARKET VALUE, TIME VALUE, AND
INTRINSIC VALUE FOR AN AMERICAN CALL

Profit

The red line shows

lue Long 1 call
the payoff at Va
maturity, not profit, r ket
of a call option. Ma

Note that even an Intrinsic value

out-of-the-money ST
option has value— Time value
time value.

Out-of-the-money In-the-money
Loss E
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved.
 EUROPEAN OPTION PRICING RELATIONSHIPS

Consider two investments:

1 Buy a European call option on the British pound futures
contract. The cash flow today is –Ce.
2 Replicate the upside payoff of the call by:
 Borrowing the present value of the dollar, exercise price of the
call in the U.S. at i$ , the cash flow today is
E
(1 + i$)

 Lending the present value of ST at i£, the cash flow today is

ST
–
(1 + i£)
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 7-25
 EUROPEAN OPTION PRICING RELATIONSHIPS

 When the option is in-the-money, both strategies have the same payoff.
 When the option is out-of-the-money, it has a higher payoff than the borrowing
and lending strategy.
 Thus,
ST E
Ce > Max – ,0
(1 + i£) (1 + i$)
 Using a similar portfolio to replicate the upside potential of a put, we can show
that:
E ST
Pe > Max – ,0
(1 + i$) (1 + i£)

Copyright © 2014 by the McGraw-Hill Companies,

Inc. All rights reserved. 7-26
 OPTION PRICING AND VALUATION
The Black - Scholes formula for pricing the European foreign
currency call and put are
 rf T
c  S0 e  N(d1 )  Ee rhT  N(d 2 )
p  [ E  N( d 2 )  FT  N( d1 )]e  rhT

where
F  1
ln  T   σ 2T
E  2
d1   d 2  d1   T
 T

c = premium on a European call

p = premium on a European put
S = spot exchange rate (domestic currency/foreign currency)
( r  r )T
F = continuous compounding Forward rate Ft  St e h f
E = exercise or strike price, T = time to maturity
rd = domestic interest rate, rf = foreign interest rate
σ = Volatility (standard deviation of percentage changes of the exchange rate)
OPTION PRICING AND VALUATION
e-rT = continuously compounding discount factor (e=2.71828182…)
(1+12%)1  1.12
(1  12% / 2) 2  1.1236
(1  12% /12)12  1.126825
(1  12% / 365)365  1.127446
e12%1  1.1274969

ln = natural logarithm operator

N(x) = cumulative distribution function for the standard normal
distribution, which isx defined based
x 1 on the probability density
x 2

function for the =  n(x)dx=

N(x)standard 
normal e 2 dx
distribution, n(x), i.e.,
- -
2
 OPTION PRICING AND VALUATION
• The pricing of currency options depends on six
parameters:
– Current spot exchange rate ($1.7/ ￡ )
– Time to maturity (90 days)
– Strike price ($1.72/ ￡ )
– Domestic risk free interest rate (r$ = 8%)
– Foreign risk free interest rate (r ￡ = 7.8%)
– Volatility (10% per annum)
Based on the above parameters, the call option premium is
$0.0246/ ￡ (this result is calculated based on the Black-Scholes
formula in the excel file “GK” Garman Kohlhagen)
 Inputs Outputs
Spot rate (DC/FC e.g. USD/EUR) 170 Call Price = 2.4666
Strike price 172
volatility (annualized) 10.00% Put Price = 4.3453
domestic interest rate (annualized) 8.00%
foreign interest rate (annualized) 7.80%
time to maturity in days 90
time to maturity in years 0.25

30
11/23/22 31
 Exhibit: Intrinsic Value, Time Value & Total Value for a Call Option
on British Pounds with a Strike Price of $1.70/£

Option Premium
(US cents/£)
-- Valuation on first day of 90-day maturity --
6.0
5.67
Total value
5.0

4.0 4.00
3.30

3.0

2.0 1.67
Time value
1.0 Intrinsic
value
0.0
1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74

Spot Exchange rate ($/£)

 Exhibit: Intrinsic Value, Time Value & Total Value for a Call Option
on British Pounds with a Strike Price of $1.70/£
FX Call Option Value and intrinsic value
20.00
Call Value (Garman-Kohlhagen modified Black-Scholes)

18.00

16.00
Total value
14.00

12.00

10.00

8.00

6.00
3.30
Intrinsic
4.00
value
2.00
Time value
0.00
157.2 158.5 159.8 161.0 162.3 163.6 164.9 166.1 167.4 168.7 170.0 171.2 172.5 173.8 175.1 176.3 177.6 178.9 180.2 181.4 182.7 184.0 185.3
5 3 0 8 5 3 0 8 5 3 0 8 5 3 0 8 5 3 0 8 5 3 0
Spot exchange rate
 OPTION PRICING AND VALUATION
• The total value (premium) of an option is equal to the
intrinsic value plus time value
• Time value captures the portion of the option value due to the
volatility in the underlying asset during the option life
– The time value of an option is always positive and declines with time,
reaching zero on the maturity date
• Intrinsic value is the financial gain if the option is exercised
immediately
– On the date of maturity, an option will have a value equal to its
intrinsic value (due to the zero time value at maturity)
CURRENCY OPTION PRICING SENSITIVITY
• If currency options are to be used effectively, either for
the purposes of speculation or risk management, the
traders need to know how option values react to their
various factors, including S, K, T, rf, rd, and σ
• More specifically, we will study the sensitivity of
option values with respect to S, K, T, rf, rd, and σ
• These sensitivities are often denoted with Greek letters,
so they also have the name “Greeks” or “Greek letters”
 DELTA
• Spot rate sensitivity (delta):
– Delta is defined as the rate of change of option price with
respect to the price of the spot exchange rate.
c
Delta  (for calls)   e-rf T N(d1 ) > 0
S
p
Delta  (for puts)   e-rf T N(-d1 ) < 0
S

– Delta is in essence the slope of the tangent line of the option

value curve with respect to the spot exchange rate
– For calls, Δ is in [0, 1], and for puts, Δ is in [-1, 0]
– For call (put) options, the higher (lower) the delta, the call
(put) option is more in the money and thus the greater the
probability of the option expiring with a positive payoff
15
7.
25
15
8.
53
15
9.
80
16
1.
08
16
2.
35
16
3.
63
16
4.
90
16
6.
18
16
7.
45
16
8.
73
17
0.
00
17
1.
28
17
2.
55
17
3.
83

Spot exchange rate

17
5.
DELTA

10
17
6.
38
17
7.
65
17
8.
93
18
0.
20
18
1.
48
18
2.
75
18
4.
03
18 Delta (N(d1)
5.
30
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
 DELTA
• For the example, the delta of the option is 0.5, so the change of the spot
exchange rate by ±$0.01/ ￡ will cause the change of the option value
approximately by 0.5× ±$0.01 = ±$0.005. More specifically, the option
value will become $0.033 ± $0.005
• Please note that the Delta estimation works well only when the change of
the exchange rate S is small. (If the spot exchange rate increases by
$0.1/ ￡ , the Delta estimation predicts the option value becoming $0.083.
• The larger the absolute value of Delta, the larger risk the portfolio is
exposed to the exchange rate changes
 THETA
• Time to maturity sensitivity (theta): #
– Option values increase with the length of time to maturity
c
Theta θ (for calls)  0
T
p
Theta θ (for puts)  0
T

– A trader with find longer maturity options better values, giving

trader the ability to alter an option position without suffering
significant time value
 THETA
• 90 to 89 days:
 premium cent 3.3  3.28
theta     0.02
 time 90  89

• 15 to14 days
 premium cent 1.37  1.32
theta     0.05
 time 15  14
• 5 to 4 days
 premium cent 0.7929  0.7093
theta     0.08
 time 54
• The rapid deterioration of option value in the last days prior to
expriration day
Theta: Option Premium Time value Deterioration

※ The negative slope means the option value decreases with the time
approaching the expiration date
※ For the at-the-money options, the decay of option values accelerates
when the time approaches the expiration date
 VEGA
• Sensitivity to volatility (Vega): #
– The vega for calls and puts are the same

c
Vega ν (for calls)  =Se-rf T n(d1 ) T  0
σ
p
Vega ν (for puts)  =Se-rf T n(d1 ) T  0
σ

– Volatility is important to option value because it measures the

exchange rate’s likelihood to move either into or out of the range in
which the option will be exercised
– The positive value of vega implies that both call and put values rise
(fall) with the increase (decrease) of σ
– The intuition for positive vega of both calls and puts is that since
the options give the holder the right to fix the purchasing or the
selling prices, options are more valuable in the scenario with higher
 VEGA
• Volatility increase 1%, from 10%  11%:

 premium $0.036  $0.033

Vega     0.30
 volatility 11 %  10%
• If the volatility rise, the risk of the option being exercised is
increasing, the option premium would be increasing
 RHO AND PHI
• Sensitivity to the domestic interest rate is termed as rho
c
Rho ρ (for calls)  =KTe -rd T N(d 2 ) > 0
rd
p
Rho ρ (for puts)  =  KTe -rd T N(-d 2 ) < 0
rd
※rd↑, domestic currency↓, foreign currency↑, because the call (put) can
fix the purchase (sale) price of the foreign currency, call↑ and put↓
• Sensitivity to the foreign interest rate is termed as phi
c
Phi φ (for calls)  =  STe -rf T N(d1 ) < 0
rf
p
Phi φ (for puts)  =STe -rf T N(-d1 ) > 0
rf

※rf↑, domestic currency↑ , foreign currency↓, because the call (put)

can fix the purchase (sale) price of the foreign currency, call↓ and put↑
 Rho
• US dollar interest rate increase 1%, from 8%  9%:

 premium $0.035  $0.033

Rho     0. 2
 US$ int erest rate 9 . 0 %  8 . 0%
• If the US dollar interest rate increase of 1%, the ATM call option
premium increase from $0.033 to $0.035/£.
 Phi
• British Pound interest rate increase 1%, from 8%  9%:

 premium $0.031  $0.033

Phi      0. 2
 BP int erest rate 9.0%  8.0%
• If the £ interest rate increase of 1%, the ATM call option premium
decrease from $0.033 to $0.031/£.
• Phi value is -0.2
Interest Differentials (rd – rf) and Call Option Premiums
Option premium (U.S. cents/ ￡ )

9.0

8.0

7.0

6.0
ITM call (K=$1.65/ ￡ )
5.0 ATM call (K=$1.70/ ￡ )

OTM call (K=$1.75/ ￡ )

4.0

3.0

2.0

1.0

0.0
-0.06 -0.04 -0.02 -3.46944695195361E-17 0.02 0.04 0.06
rUS$ – r ￡

※ When the interest rate differential (rd – rf) increases, the foreign
currency call value indeed increases
 RHO AND PHI
• Speculation strategy based on the expectation of the
domestic interest rate
– Because rd↑  c↑ and rd ↓  p↑, a trader should purchase a
call (put) option on foreign currency before the domestic
interest rate rises (declines). This timing will allow the trader
to purchase the option before its price increases
 SUMMARY OF OPTION VALUE SENSITIVITY
Greek Definition Interpretation

Delta Δ Expected change in the option value The higher (lower) the delta, the more
for a small change in the spot rate likely the call (put) will move in-the-
money

Theta Θ Expected change in the option value For at-the-money options, premiums are
for a small change in time to relatively insensitive until the final 30
expiration days

Vega υ Expected change in the option value Option values rise with increases in
for a small change in volatility volatility both for calls and puts

Rho ρ Expected change in the option value Increases in domestic interest rates
for a small change in domestic cause increasing call values and
interest rate decreasing put values

Phi φ Expected change in the option value Increases in foreign interest rates cause
for a small change in foreign interest decreasing call values and increasing put
rate values