A Currency Options Primer

Disclaimer xi

1 Introduction 1

1.1 The forward foreign exchange market 1

1.2 The currency options market 1

1.3 The alternatives to currency options 2

1.4 The users 2

1.5 Whose domain? 2

PART I MARKET OVERVIEW 3

2 The Foreign Exchange Market 5

2.1 Twenty-four-hour global market 5

2.2 Value terms 5

2.3 Coffee houses 6

2.4 Spot and forward market 6

2.5 Alternative markets 7

2.6 Currency options 7

2.7 Concluding remarks 8

3 A Brief History of the Market 9

3.1 The barter system 9

3.2 The introduction of coinage 9

3.3 The expanding British Empire 10

3.4 The gold standard 10

3.5 The Bretton Woods system 11

3.6 The International Monetary Fund and the World Bank 11

3.7 The dollar rules OK 12

3.8 Special drawing rights 12

3.9 A dollar problem 13

3.10 The Smithsonian agreement 13

3.11 The snake 13

3.12 The dirty float 13

3.13 The European Monetary System 14

3.14 The Exchange Rate Mechanism 14

3.15 The European Currency Unit 15

3.16 The Maastricht Treaty 15

3.17 The Treaty of Rome 15

3.18 Economic reform 16

3.19 A common monetary policy 16

3.20 A single currency 16

3.21 Currency options 18

3.22 Concluding remarks 20

4 Market Overview 21

4.1 Global market 21

4.2 No physical trading floor 21

4.3 A “perfect” market 21

4.4 The main instruments 22

4.5 Comparisons of options with spot and forwards 23

4.6 The dollar’s role 24

4.7 Widely traded currency pairs 24

4.8 Concluding remarks 25

5 Major Participants 27

5.1 Governments 27

5.2 Banks 27

5.3 Brokering houses 29

5.4 International Monetary Market 29

5.5 Money managers 29

5.6 Corporations 29

5.7 Retail clients 29

5.8 Others 30

5.9 Speculators 30

5.10 Trade and financial flows 30

6 Roles Played 33

6.1 Market makers 33

6.2 Price takers 33

6.3 A number of roles 33

6.4 A number of roles – options 34

6.5 Concluding remarks 34

7 Purposes 35

7.1 Commercial transactions 35

7.2 Funding 35

7.3 Hedging 35

7.4 Portfolio investment 36

7.5 Personal 36

7.6 Market making 36

7.7 Transaction exposure 36

7.8 Translation exposure 37

7.9 Economic exposure 37

7.10 Concluding remarks 37

8 Applications of Currency Options 39

9 Users of Currency Options 41

9.1 Variety of reasons 41

9.1.1 Example 1 42

9.1.2 Example 2 43

9.1.3 Example 3 43

9.2 Hedging vs speculation 44

Glossary of foreign exchange terms 45

PART II CURRENCY OPTIONS – THE ESSENTIALS 47

10 Definitions and Terminology 49

10.1 Call option 50

10.2 Put option 50

10.3 Parties and the risks involved 51

10.4 Currency option risk/reward perception 51

10.5 Currency or dollar call or put option? 52

10.6 Strike price and strike selection 52

10.7 Exercising options 53

10.8 American and European style options 53

10.9 In-, at- or out-of-the-money 55

10.10 The premium 57

10.11 Volatility 59

10.12 Break-even 60

11 The Currency Option Concept 61

12 The Currency Options Market 63

12.1 Exchange vs over-the-counter 63

12.2 Standardised Options 65

12.3 Customised options 66

12.4 Features of the listed market 67

12.5 Comparisons 69

12.6 Where is the market? 69

12.7 Concluding remarks 69

13 Option Pricing Theories 71

13.1 Basic properties 71

13.2 Theoretical valuation 72

13.3 Black-Scholes model 73

13.4 Examples of other models 74

13.5 Pricing without a computer model 76

13.6 Educated guess 76

13.7 The price of an option 76

13.8 Option premium profile 78

13.9 Time value and intrinsic value 78

13.10 Time to expiry 79

13.11 Volatility 79

13.12 Strike price and forward rates 82

13.13 Interest rates 82

13.14 American vs European 83

13.15 Concluding remarks 84

14 The Greeks 85

14.1 Delta 85

14.2 Gamma 88

14.3 Theta 90

14.4 Vega 92

14.5 Rho 92

14.6 Beta and omega 93

15 Payoff and Profit/Loss Diagrams 95

15.1 Payoff diagram 95

15.2 Profit diagram 95

15.3 The option writer 97

15.4 Put option 97

15.5 Put option writer 98

15.6 Basic option positions 98

15.7 Graph addition 100

15.8 Profit/loss profiles for ten popular option strategies 101

15.9 Concluding remarks 102

16 Basic Properties of Options 105

16.1 Option values 105

16.2 Put/call parity concept 106

16.3 Synthetic positions 108

17 Risk Reversals 111

17.1 Understanding risk reversals 111

17.2 Implications for traders 112

17.3 Implications for hedgers 113

17.4 Concluding remarks 114

18 Market Conventions 115

18.1 Option price 115

18.2 What rate to use? 116

18.3 Live price 116

18.4 Pricing terms 117

18.5 Premium conversions 117

18.6 Settlement 117

18.7 How is an option exercised? 118

18.8 Risks 118

18.9 Concluding remarks 119

Basic option glossary 121

PART III CURRENCY OPTION PRODUCTS 125

19 Vanilla Options 127

19.1 Long options 127

19.2 Short options 127

19.3 Straddle 128

19.4 Strangle 129

19.5 Cylinder 130

19.6 Collar 131

19.7 Participating forward 131

19.8 Ratio forward 132

19.9 Added extras to vanilla options 133

20 Common Option Strategies 135

20.1 Directional options 137

20.2 Precision options 139

20.3 Locked trade options 144

21 Exotic Options 145

21.1 Barriers 145

21.2 Average rates 148

21.3 Lookback and ladder 149

21.4 Chooser 152

21.5 Digital (binary) 153

21.6 Baskets 154

21.7 Compound 156

21.8 Variable notional 157

21.9 Multi-factor 158

22 Structured Currency Options 159

22.1 Trigger forward 159

22.2 Double trigger forward 160

22.3 At maturity trigger forward 161

22.4 Forward extra 161

22.5 Weekly reset forward 162

22.6 Range binary 163

22.7 Contingent premium 163

22.8 Wall 164

22.9 Corridor 165

23 Case Studies 167

23.1 Hedging 167

23.2 Trading 169

23.3 Investment 170

23.4 Bid to offer exposure 171

23.5 Concluding remarks 173

24 Option Hedge Matrix 175

Exotic currency option glossary 187

25 Concluding Remarks 193

Index 195